<PAGE> 1
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MARCH 25, 1998
REGISTRATION NO. 333-
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM S-11
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
REALTRUST ASSET CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS GOVERNING INSTRUMENTS)
2855 EAST COTTONWOOD PARKWAY, SUITE 500
SALT LAKE CITY, UTAH 84121
(ADDRESS OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
JOHN D. FRY, CHIEF EXECUTIVE OFFICER
REALTRUST ASSET CORPORATION
2855 EAST COTTONWOOD PARKWAY, SUITE 500
SALT LAKE CITY, UTAH 84121
(801) 365-3000
(NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER,
INCLUDING AREA CODE, OF AGENT FOR SERVICE)
COPIES TO:
<TABLE>
<S> <C>
CHRISTOPHER A. WILSON, ESQ. PETER T. HEALY, ESQ.
JEFFERS, WILSON, SHAFF & FALK, LLP O'MELVENY & MYERS LLP
18881 VON KARMAN AVENUE, SUITE 1400 275 BATTERY STREET
IRVINE, CALIFORNIA 92612 SAN FRANCISCO, CALIFORNIA 94111
TELEPHONE: (714) 660-7700 TELEPHONE : (415) 984-8700
FACSIMILE: (714) 660-7799 FACSIMILE: (415) 984-8701
</TABLE>
APPROXIMATE DATE OF COMMENCEMENT OF THE PROPOSED SALE OF THE SECURITIES TO THE
PUBLIC:
AS SOON AS PRACTICABLE AFTER THIS REGISTRATION STATEMENT BECOMES EFFECTIVE.
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
check the following box. [ ]
CALCULATION OF REGISTRATION FEE
<TABLE>
<CAPTION>
=================================================================================================================================
TITLE OF EACH CLASS OF AMOUNT TO BE PROPOSED MAXIMUM PROPOSED MAXIMUM AMOUNT OF
SECURITIES TO BE REGISTERED REGISTERED(1) OFFERING PRICE PER SHARE AGGREGATE OFFERING PRICE(2) REGISTRATION FEE
<S> <C> <C> <C> <C>
- ---------------------------------------------------------------------------------------------------------------------------------
Common Stock, par value $.001... 5,750,000 $16.00 $ 92,000,000 $27,140.00
Common Stock Purchase
Warrants...................... 5,750,000 (3) (3) (3)
Representative's Warrants....... 172,500 $ 0.01 $ 1,725 $ 0.51
Common Stock, par value $.001
per share, issuable upon
exercise of Common Stock
Purchase Warrants(4).......... 5,750,000 $16.00 $ 92,000,000 $27,140.00
Common Stock, par value $.001
per share, issuable upon
exercise of Representative's
Warrants(4)................... 172,500 $16.00 $ 2,760,000 $ 814.20
------------ ----------
Total................. $186,761,725 $55,094.11
=================================================================================================================================
</TABLE>
(1) Assumes exercise of an over-allotment option granted to the Underwriters to
purchase 750,000 Units.
(2) Estimated solely for the purpose of computing the amount of the registration
fee pursuant to Rule 457(a).
(3) Included in the Units at no additional cost.
(4) This Registration Statement also covers any additional shares of Common
Stock which may become issuable by virtue of the anti-dilution provisions of
the Common Stock Purchase Warrants and Representative's Warrants. No
additional registration fee is included for these shares.
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THE REGISTRATION STATEMENT
SHALL BE COME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID
SECTION 8(a), MAY DETERMINE.
================================================================================
<PAGE> 2
SUBJECT TO COMPLETION, DATED MARCH , 1998
[logo] 5,000,000 UNITS
REALTRUST ASSET CORPORATION
EACH UNIT TO CONSIST OF ONE SHARE OF COMMON STOCK AND ONE STOCK PURCHASE WARRANT
All of the units (the "Units") offered hereby are being sold by RealTrust
Asset Corporation, a newly formed Maryland corporation (the "Company"). Each
Unit consists of one share of Company common stock, par value $.001 per share
("Common Stock"), and one warrant to purchase one share of Common Stock (a
"Warrant"). The Warrants included with the Units will automatically detach from
the Common Stock six months after the closing of this offering (the "Offering").
See "Description of Capital Stock."
Each Warrant entitles the holder thereof to purchase one share of Common
Stock (a "Warrant Share"), subject to certain anti-dilution adjustments. The
Warrants will become exercisable six months after the initial closing of this
Offering and will remain exercisable until 5:00 p.m. New York Time on the third
anniversary of the date the Warrants first become exercisable, at an exercise
price equal to the Price to Public (as set forth below). See "Underwriting." For
purposes of this Prospectus, the Units, the Common Stock, the Warrants and the
Warrant Shares are referred to collectively as the "Securities" unless the
context indicates otherwise.
Prior to the closing of this Offering, there has been no public market for
the Securities. It is currently estimated that the Price to Public will be
between $14.00 and $16.00 per share. See "Underwriting" for information relating
to the factors considered in determining the Price to Public. The Company
intends to apply for quotation of the Units on the American Stock Exchange under
the symbol "RTA.U." The Company intends to apply for quotation of the Common
Stock and Warrants on the American Stock Exchange effective on the date the
Warrants automatically detach from the Common Stock under the symbols "RTA" and
"RTA.W," respectively.
------------------------
SEE "RISK FACTORS" COMMENCING ON PAGE FOR INFORMATION THAT SHOULD BE
CONSIDERED BY PROSPECTIVE INVESTORS. THESE RISKS INCLUDE:
- - Sudden interest rate fluctuations may reduce income from operations.
- - Limited operating history and management experience may affect future
performance.
- - Failure to implement a successful leverage strategy may reduce income from
operations.
- - Higher risk of delinquency and foreclosure on Subprime Mortgage Loans.
- - Adoption of the 1999 Budget Plan may require a significant change in the
Company's operations and may reduce earnings and distributions.
- - Mortgage loan prepayments may reduce operating income.
- - Failure to successfully manage interest rate risks may affect results of
operations.
- - Failure to maintain REIT status may reduce earnings and distributions.
- - Competition for Subprime Mortgage Loans may effect future performance.
- - Defaults on Mortgage Loans held by the Company may reduce earnings and
distributions or result in losses.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION, NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED
UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION
TO THE CONTRARY IS A CRIMINAL OFFENSE.
<TABLE>
<S> <C> <C> <C>
====================================================================================================================
PRICE TO PUBLIC UNDERWRITING DISCOUNT(1)(2) PROCEEDS TO COMPANY(3)
- --------------------------------------------------------------------------------------------------------------------
Per Unit.................. $ $ $
- --------------------------------------------------------------------------------------------------------------------
Total(4).................. $ $ $
====================================================================================================================
</TABLE>
(1) Excludes value of the Warrants to be issued to Stifel, Nicolaus & Company,
Incorporated (the "Representative"), to purchase 150,000 shares of Common
Stock (172,500 shares of Common Stock if the Underwriters' over-allotment
option is exercised) at an exercise price equal to the Price to Public (the
"Representative's Warrants").
(2) The Company and certain of its affiliates have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933, as amended. See "Underwriting."
(3) Before deducting expenses of this offering payable by the Company, estimated
to be $850,000.
(4) The Company has granted the Underwriters an option exercisable within 30
days after the date of this Prospectus to purchase up to 750,000 additional
Units on the same terms and conditions set forth above to cover
over-allotments, if any. If all such additional Units are purchased, the
total Price to Public, Underwriting Discount and Proceeds to Company will be
$ , $ and $ , respectively. See "Underwriting."
------------------------
The Securities are offered by the Underwriters subject to receipt and
acceptance by them, prior sale and the Underwriters' right to reject any order
in whole or in part and to withdraw, cancel or modify the offer without notice.
It is expected that delivery of certificates for the Securities will be made
through The Depository Trust Company, on or about , 1998.
STIFEL, NICOLAUS & COMPANY EVEREN SECURITIES, INC.
INCORPORATED
, 1998
INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A
REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY
OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES
EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE
SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALES OF THESE SECURITIES
IN ANY STATE IN WHICH SUCH OFFER SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR TO
REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY SUCH STATE.
<PAGE> 3
TABLE OF CONTENTS
<TABLE>
<S> <C>
PROSPECTUS SUMMARY............................... 1
The Company.................................... 1
Management..................................... 2
Competitive Advantages......................... 3
Business Strategies............................ 3
Structure and Formation Transactions........... 6
Summary Risk Factors........................... 8
Dividend Policy and Distributions.............. 11
The Offering................................... 11
Certain Transactions........................... 12
RISK FACTORS..................................... 14
General........................................ 14
Risks Associated with a New Enterprise......... 14
Limited Operating History of the Company, Net
Losses and Failure to Achieve Projected
Levels of Mortgage Loan Originations....... 14
Lack of Relevant Experience.................. 14
Dependence on Key Personnel for Successful
Operations................................. 15
Risk of Future Revisions in Policies and
Strategies by Board of Directors........... 15
Need for Additional Capital to Support Future
Growth; Risk of Potential Future
Offerings.................................. 15
Risks Related to Economic Conditions......... 15
Risks Associated with Mortgage Lending
Operation.................................... 16
Interest Rate Fluctuations; Impact on
Operations and Net Interest Income......... 16
Mortgage Asset Commitment Risks.............. 16
Availability of Funding Sources; Dependence
on Lenders................................. 16
Risk of Loss Resulting From Default.......... 17
Competition in the Subprime Mortgage Lending
Market; Changes to the Competitive
Environment................................ 18
Dependence on Independent Mortgage Brokers
and Correspondents......................... 18
Elimination of Lender Payments to Brokers.... 18
Reliance on Secondary Market Purchasers for
Mortgage Loan Sales........................ 19
Legislation and Regulation................... 19
Environmental Liabilities.................... 20
Risks Associated with the Acquisition and
Management of a Portfolio of Mortgage
Assets....................................... 20
Operations Risk.............................. 20
Dependence on Structured Debt Financing
Market and Credit Enhancements; Potential
Increased Cost of Agreement with
ContiFinancial Corporation................. 21
Effect of Borrowings on Portfolio
Management................................. 21
Potential Effects of Differences Between
Mortgage Asset and Borrowing
Characteristics............................ 21
Increased Levels of Prepayment May Reduce Net
Interest Income............................ 22
High Loan-to-Value Products.................. 23
Higher Delinquency and Loss Rates with
Subprime Mortgage Borrowers................ 23
Potential Consequences of Failing to
Effectively Hedge Against Interest Rate
Changes.................................... 23
Consequences Associated with Hedging......... 24
Potential Effect of the Company's Owning
Subordinated Classes of Debt............... 24
Contingent and Residual Risks in Structured
Debt Financings............................ 24
Illiquidity of Mortgage Assets............... 25
Risk of Lack of Geographic Diversification... 25
Risks Associated with Servicing.............. 25
Risks of Substantial Leverage and Potential
Losses in Connection with Borrowings......... 26
Failure to Achieve Optimal Degree of
Leverage................................... 26
Failure to Refinance Outstanding
Borrowings................................. 26
Effect of Decline in Market Value of Mortgage
Assets; Margin Calls....................... 26
Counterparty Risks........................... 27
Potential Consequences of Bankruptcy......... 27
Risks Associated with the Company's Combined
Operations and this Offering................. 27
Absence of a Public Trading Market;
Fluctuations in Market Price............... 27
Consequences of Failure to Maintain REIT
Status; Company Subject to Corporate Level
Tax........................................ 27
Potential Effects of 1999 Budget Plan........ 28
Consequences of Failure to Qualify for
Exemption from Investment Company Act...... 29
Issuance of Preferred Stock.................. 29
Restrictions on Ownership of Capital Stock... 29
Control by Management and Certain Affiliates;
No Voting Control of the Proposed Taxable
Subsidiary; Potential Conflicts of
Interest................................... 30
THE COMPANY...................................... 31
USE OF PROCEEDS.................................. 31
DIVIDEND POLICY AND DISTRIBUTIONS................ 32
DIVIDEND REINVESTMENT PLAN....................... 32
DILUTION......................................... 33
CAPITALIZATION................................... 34
SELECTED FINANCIAL DATA.......................... 35
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS............ 36
Overview....................................... 36
Certain Accounting Policies and Procedures..... 36
Results of Operations.......................... 37
Liquidity and Capital Resources................ 37
Inflation...................................... 38
Year 2000 Compliance........................... 38
BUSINESS......................................... 39
General........................................ 39
Competitive Advantages......................... 40
Overview of Subprime Mortgage Market........... 42
Industry Developments.......................... 43
Mortgage Lending Business...................... 44
Marketing and Production Strategy.............. 45
Underwriting and Quality Control Strategies.... 50
Financing Loans Held for Sale and Investment
Prior to Structured Debt Financing........... 56
Information Management Systems................. 57
</TABLE>
(i)
<PAGE> 4
<TABLE>
<S> <C>
Mortgage Investment Portfolio.................. 58
Retained Interests in Structured Debt
Instruments.................................. 60
Capital and Liquidity Management............... 61
Capital Allocation Guidelines.................. 62
Servicing Activities........................... 63
Interest Rate Risk Management.................. 64
Credit Risk Management......................... 65
Mortgage Loan Prepayments...................... 66
Future Changes in Operating, Investment and
Accounting Policies.......................... 67
MANAGEMENT....................................... 69
Directors and Executive Officers............... 69
Key Employees.................................. 70
Terms of Directors and Officers................ 71
Committees of the Board........................ 72
Compensation of Directors...................... 72
Compensation Committee Interlocks.............. 72
Executive Compensation......................... 72
Stock Option Grants............................ 77
Individual Grants.............................. 77
STRUCTURE AND FORMATION TRANSACTIONS............. 79
Structure of the Company....................... 79
RealTrust Asset Corporation.................... 79
The Taxable Subsidiary......................... 79
Formation Transactions......................... 80
CERTAIN TRANSACTIONS............................. 81
ContiFinancial Corporation..................... 81
Capstone Investments, Inc...................... 82
Formation Transactions......................... 83
Employment Agreements.......................... 83
PRINCIPAL STOCKHOLDERS........................... 84
DESCRIPTION OF CAPITAL STOCK..................... 84
General........................................ 84
Historical Capital Structure................... 84
Common Stock................................... 85
Preferred Stock................................ 85
Warrants and Option............................ 85
Repurchase of Shares and Restriction on
Transfer..................................... 88
Limitation of Liability and Indemnification.... 91
Control Share Acquisitions..................... 92
Business Acquisitions Statutes................. 92
Transfer Agent and Registrar................... 93
SHARES ELIGIBLE FOR FUTURE SALE.................. 93
General........................................ 93
Registration Rights............................ 93
FEDERAL INCOME TAX CONSIDERATIONS................ 95
General........................................ 95
Opinion of Counsel............................. 95
Qualification as a REIT........................ 96
Taxation of the Company........................ 100
Taxation of Taxable Subsidiary................. 100
Termination or Revocation of REIT Status....... 101
Taxation of the Company's Stockholders......... 101
Taxation of Tax-Exempt Entities................ 103
Foreign Investors.............................. 103
Recordkeeping Requirement...................... 103
Backup Withholding............................. 104
Recent Legislative Proposals................... 104
State and Local Taxes.......................... 104
ERISA Considerations........................... 104
UNDERWRITING..................................... 106
LEGAL MATTERS.................................... 107
EXPERTS.......................................... 108
ADDITIONAL INFORMATION........................... 108
GLOSSARY......................................... 109
TABLE OF CONTENTS TO FINANCIAL STATEMENTS........ F-1
</TABLE>
------------------------
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE UNITS. SUCH
TRANSACTIONS MAY INCLUDE STABILIZING BIDS AND PURCHASES IN THE OPEN MARKET,
OVER-ALLOTMENTS, SYNDICATE SHORT COVERING TRANSACTIONS AND PENALTY BIDS. FOR A
DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING."
(ii)
<PAGE> 5
PROSPECTUS SUMMARY
The summary information below should be read in conjunction with, and is
qualified in its entirety by, the detailed information appearing elsewhere in
this Prospectus. All references to the "Company" shall include all Qualified
REIT subsidiaries and all taxable subsidiaries through which the Company
conducts its business, unless the context indicates otherwise. Capitalized terms
used herein shall have the definitive meanings assigned to them in the text
below and in the Glossary beginning at page .
This Prospectus contains forward-looking statements within the meaning of
Section 27A of the Securities Act. Forward-looking statements may be found
throughout this Prospectus, particularly under "Prospectus Summary," "Use of
Proceeds," "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Business." Such forward-looking statements are
indicated by the use of such words as "intends," "expects," "may,"
"anticipates," "estimates," "desires," "believes" and similar expressions.
Actual results may differ from those described by forward-looking statements as
a result of many risks and uncertainties, including, but not limited to, those
described under "Risk Factors." Prospective investors are advised not to rely
upon forward-looking statements, but rather base their investment decision on
the Company's actual results to date.
The discussion of the business, operations, structure and formation of the
Company in this Prospectus is qualified in its entirety by the description of
the potential effects of the 1999 Budget Plan set forth below under
"Business -- Industry Developments."
THE COMPANY
RealTrust Asset Corporation, a newly formed Maryland corporation
("RealTrust" or, with its subsidiaries, the "Company"), is a specialty finance
company engaged in the business of originating, purchasing, selling and
servicing mortgage loans secured (i) primarily by first mortgages on
single-family residences ("First Lien Mortgage Loans") and (ii) to a lesser
extent by second lien Mortgage Loans ("Second Lien Mortgage Loans"; collectively
with First Lien Mortgage Loans, "Mortgage Loans"). RealTrust intends to elect to
be taxed as a real estate investment trust ("REIT"). The Company originates
Mortgage Loans through 12 wholesale and two retail branch offices of CMG Funding
Corp., a Delaware corporation and a taxable subsidiary of RealTrust (the
"Taxable Subsidiary"). In addition, the Company has built a correspondent
lending operation that began purchasing Subprime Mortgage Loans (as defined
below) in the fourth quarter of 1997.
The Company's mortgage lending operations originate and purchase fixed and
adjustable-rate Prime Mortgage Loans (as defined below) and Subprime Mortgage
Loans (as defined below). The Company intends to build a portfolio of primarily
Subprime Mortgage Loans financed with structured debt instruments while selling
its Prime Mortgage Loans and a portion of its Subprime Mortgage Loan production
for cash gains. The portfolio is expected to generate net interest income,
which, upon election of REIT status, will not be taxed at the corporate level.
In addition, the sale of Prime Mortgage Loans and selected Subprime Mortgage
Loans originated or purchased by the Company will be conducted through the
Taxable Subsidiary and is expected to generate current income and cash flow to
fund in part the Company's mortgage lending operations. See
"Business -- Industry Developments." For the fiscal year ended December 31,
1997, the Company had originated or purchased $246.9 million of Subprime
Mortgage Loans, including $63.1 million of Subprime Mortgage Loans purchased
through its correspondent operations, and originated $260.5 million of Prime
Mortgage Loans. The Company is now and intends to remain self-advised and
self-managed.
To date, the Company has sold substantially all of its Subprime Mortgage
Loan production on a servicing-released basis, primarily to ContiFinancial
Corporation (with its affiliates ContiMortgage Corporation, ContiTrade Services,
L.L.C., and ContiFinancial Services Corporation, "ContiFinancial Corporation").
Subsequent to the closing of this Offering, the Company will shift from selling
all of its Subprime Mortgage Loan production to building a portfolio of Subprime
Mortgage Loans financed with structured debt. See "Business -- Industry
Developments" and "Risk Factors -- Risks Associated with the Acquisition and
Management of a Portfolio of Mortgage Assets." The Company intends to use the
net proceeds of this
1
<PAGE> 6
Offering to provide the equity base for owning a portfolio of Subprime Mortgage
Loans and realizing any net interest income from such portfolio.
For the fiscal year ended December 31, 1997, the Company was taxed as a "C"
corporation and, therefore, was subject to tax on any earnings for 1997.
RealTrust will elect to be taxed as a REIT under the Internal Revenue Code of
1986, as amended (the "Code"), beginning with the tax year ending December 31,
1998. Upon such election, RealTrust will generally not be subject to federal
income tax to the extent that it distributes its earnings to its stockholders
and maintains its qualification as a REIT. Management believes that a REIT is
the most desirable structure for owning Mortgage Assets (as defined below) due
to the elimination of corporate-level income taxation. In addition, because the
Company will not accept deposits like traditional lenders, it will be subject to
substantially less regulatory oversight and will incur lower compliance expenses
compared to banks, thrifts and other originators or holders of Mortgage Assets.
The Company's principal business objectives are to increase earnings per
share, to increase cash available for distribution to stockholders and to
enhance stockholder value. The Company intends to accomplish these goals
primarily by capitalizing on the relatively high yields available from investing
in Subprime Mortgage Loans. The Company will derive income from two principal
business activities as follows:
(i) the operation of the Company's mortgage origination business which
will generate income from its mortgage banking activities and will supply
adjustable-rate Subprime Mortgage Loans for long-term investment through
the proposed tax-advantaged REIT structure; and
(ii) the management of an investment portfolio of Mortgage Loans and
securities backed by Mortgage Loans ("Mortgage Securities" and, together
with Mortgage Loans, "Mortgage Assets") which, similar to banks and savings
institutions, will generate net interest income based upon the difference
between the interest earned on its Mortgage Assets and the interest paid on
its borrowings used to acquire the Mortgage Assets.
MANAGEMENT
The Company's two primary executive officers, Mr. John D. Fry and Mr. Terry
L. Mott, collectively have extensive experience in building and operating
mortgage banking operations in a variety of environments, including building
Mortgage Loan production and management teams and creating and implementing
policies, budgets and controls. Mr. Fry, Certified Mortgage Banker (CMB), formed
the Company in February, 1996 and has been the President, Chief Executive
Officer and Chairman of the Board of Directors since inception. Mr. Fry began
his mortgage banking career in 1966. From 1984 to 1995, Mr. Fry built the
operational capacity of Goldome Realty Credit Corp., located in Buffalo, New
York, and ComUnity Lending, Inc., located in San Jose, California, to the
multi-state, multi-billion dollar Mortgage Loan funding and servicing level. Mr.
Fry commenced ComUnity Lending's subprime mortgage lending operations which
produced $8.0 million per month at the time of his departure in 1994. See
"Management."
Mr. Mott has been the Executive Vice President of the Company primarily
responsible for Mortgage Loan production and a Director since inception. Mr.
Mott began his career in mortgage banking in 1977. From 1980 to 1988, Mr. Mott
was the regional Vice President at Fleet Mortgage Corp. where he developed and
managed the retail and wholesale mortgage loan production for the western United
States. From 1988 to 1994, Mr. Mott was Executive Vice President and served on
the executive committee for Medallion Mortgage Company where he was responsible
for growing the retail and wholesale Mortgage Loan production from $5.0 million
per month to over $300.0 million per month in a period of six years. Mr. Mott
left AccuBanc Mortgage, the successor to Medallion Mortgage Company, in
December, 1995, to form the Company with Mr. Fry. See "Management."
In contemplation of this Offering and the proposed business strategy of the
Company, the Company has hired additional executive management team members,
including Mr. John P. McMurray and Mr. Steven K. Passey. Mr. McMurray joined the
Company in February, 1998, as Executive Vice President of Secondary Marketing
and Asset Liability Management. Prior to joining the Company, Mr. McMurray was
President of Keystroke Financial, Inc., a start-up internet mortgage origination
company. From 1995 to 1996,
2
<PAGE> 7
Mr. McMurray was Executive Vice President and Director, Risk Management and
Capital Markets for Crestar Mortgage Corporation where he was responsible for
interest rate and credit risk management, as well as hedging and loan sales
activities. From 1982 to 1995, Mr. McMurray served in various management
positions with BancPlus Mortgage Corp., most recently serving as Senior Vice
President, Capital Markets. Mr. McMurray is a Chartered Financial Analyst and a
Certified Public Accountant. He received a Master of Science degree in real
estate from Massachusetts Institute of Technology, a Masters of Business
Administration degree from the University of Texas, San Antonio and a Bachelor
of Science degree from Trinity University. Mr. Passey joined the Company in
October, 1997 as Senior Vice President and Chief Financial Officer. Prior to
joining the Company, Mr. Passey was employed by KPMG Peat Marwick LLP in the
financial services area for eight years, most recently as a manager responsible
for accounting and audit work for financial services companies. Mr. Passey is a
Certified Public Accountant. See "Management."
COMPETITIVE ADVANTAGES
Management believes that the Company will be able to compete effectively
against, and generate relatively attractive rates of return to stockholders
compared to, certain of its competitors as a result of:
- An experienced management team that has previously built extensive
mortgage banking operations and managed large mortgage loan investment
portfolios;
- A Mortgage Loan production franchise and investment portfolio focused on
relatively higher margin Subprime Mortgage Loans;
- Access to structured debt instruments to finance Mortgage Assets held in
the Company's investment portfolio instead of gain-on-sale
securitizations;
- The tax advantages offered by electing REIT status for fiscal year 1998
and maintaining such status thereafter;
- A self-advised and self-managed corporate governance structure which
limits potential conflicts of interest;
- Exemption from state and federal regulations imposed on banks and
thrifts and the corresponding costs of insurance and oversight; and
- The ability to sell Mortgage Loans for cash gains (see
"Business -- Industry Developments.").
BUSINESS STRATEGIES
MARKETING AND PRODUCTION STRATEGY
The Company acquires or will acquire Mortgage Loans from four sources: (i)
its wholesale channel through which Mortgage Loans are acquired from a network
of independent wholesale brokers, (ii) its correspondent channel through which
closed Mortgage Loans are purchased from other lenders, (iii) its retail channel
through which direct originations are obtained from its retail branches, and
(iv) to a lesser extent, its bulk acquisitions of Mortgage Loans from other
mortgage banks and financial institutions.
The wholesale channel, which originates Mortgage Loans through independent
wholesale brokers, accounted for $114.5 million, or 53.0%, of the Company's
Mortgage Loan production during the fourth quarter of 1997. Of the wholesale
channel Mortgage Loans originated during the fourth quarter of 1997, $68.5
million, or 59.8%, were Subprime Mortgage Loans. As of January 31, 1998, the
wholesale channel originated Mortgage Loans through 12 branch offices located
nationwide. The Company believes that it has been successful in penetrating the
broker market by providing prompt, consistent service, which includes (i)
response time efficiencies in the purchase process as a result of decentralized
underwriting, (ii) direct and frequent contact through a trained sales force,
(iii) competitive pricing, and (iv) a variety of pricing programs and Mortgage
Loan products. The Company intends to initially increase wholesale Mortgage Loan
production through expanded marketing efforts by existing branches and to
identify new areas of the United States where
3
<PAGE> 8
it will establish additional wholesale branches. The Company intends to continue
to increase the percentage of Subprime Mortgage Loans originated through its
wholesale channel.
The correspondent lending division acquires closed Subprime Mortgage Loans
through a national network of approved Mortgage Loan originators that fund and
close each Subprime Mortgage Loan using their own funds and subsequently sell
the Mortgage Loans to the Company. The correspondent lending division accounted
for $63.1 million, or 29.2%, of the Company's Mortgage Loan production during
the fourth quarter of 1997, all of which were Subprime Mortgage Loans. The goal
of the correspondent lending division is to increase the volume of Subprime
Mortgage Loan production while maintaining the comprehensive quality control
systems currently employed by the wholesale and retail divisions of the Company.
Subprime Mortgage Loans will be purchased from mortgage bankers, commercial
bankers and savings and loans on a servicing released basis. Each seller will
maintain certain eligibility criteria such as net worth requirements, Mortgage
Loan origination experience and warehouse line capability. In October, 1997, the
Company entered into a letter agreement with Nomura Asset Capital Corporation
("Nomura") to acquire from Nomura Subprime Mortgage Loans and certain
non-binding seller relationships between Nomura and several sellers through
which Nomura has actively purchased Subprime Mortgage Loans since 1994. As of
October, 1997, Nomura had purchased over $1.75 billion of Subprime Mortgage
Loans through this conduit operation. The Company views the assumption of the
Nomura seller relationships as a platform to build and develop the Subprime
Mortgage Loans necessary to implement the Company's Mortgage Asset portfolio
strategy.
The retail channel, which originates Mortgage Loans through the direct
solicitation of borrowers, accounted for $38.4 million, or 17.8%, of the
Company's Mortgage Loan production during the fourth quarter of 1997. Of the
retail channel Mortgage Loans originated during the fourth quarter of 1997, $3.8
million, or 9.9%, were Subprime Mortgage Loans. As of January 31, 1998, the
retail channel originated Mortgage Loans through two branch offices located in
Salt Lake City, Utah and Las Vegas, Nevada. The retail channel includes
traditional marketing activities conducted by retail loan officers, who seek to
identify potential borrowers through referral sources and individual sales
efforts, as well as high-volume targeted direct mail and telephone solicitation.
The Company intends to maintain Prime Mortgage Loan production and to focus on
increasing Subprime Mortgage Loan production within its existing retail branch
offices by staffing each retail office with a minimum of two Subprime Mortgage
Loan officers who will utilize direct mail and telephone solicitation methods to
generate such Mortgage Loans.
The Company may also acquire a portion of its Mortgage Asset portfolio
through occasional bulk acquisitions of Mortgage Asset pools ranging in size
from $2.0 million to $50.0 million.
UNDERWRITING AND QUALITY CONTROL
The Company underwrites all Mortgage Loans originated through its retail
and wholesale channels with a staff of in-house underwriters. The Company staffs
each office with senior underwriters with a minimum of five years experience and
trains each underwriter on the Company's underwriting policies and procedures at
the Company's headquarters in Salt Lake City, Utah. The underwriters are
permitted to staff retail or wholesale offices after approval by the Chief
Credit Officer, and are subject to a 30-day probation, during which their work
is closely scrutinized by the Company. With respect to its Correspondent
channel, the Company may delegate underwriting authority to Correspondents who
meet certain financial and performance criteria. Under the delegated
underwriting program, Mortgage Loans will be underwritten in accordance with the
Company's guidelines by the Correspondent and will be purchased on the basis of
the Correspondent's financial strength, historical Mortgage Loan quality and
other qualifications. To date, no such delegated underwriting authority has been
granted and all Mortgage Loans purchased by the Company have been fully
underwritten by the Company prior to purchase. Correspondents are required to
meet certain performance requirements established by the Company before they are
eligible to participate in the Company's correspondent seller program and must
submit to periodic reviews by the Company to ensure continued compliance with
these requirements. The Company has an extensive, systematized quality control
and audit plan currently in place to monitor the quality of the Mortgage Loans
originated and purchased, personnel and processes.
4
<PAGE> 9
LOAN SALES
The Company has historically followed a strategy of selling for cash gains
all of its Mortgage Loan originations and purchases through Mortgage Loan sales
in which the Company disposes of its entire economic interest in the Mortgage
Loans (including servicing rights) for a cash price that represents a premium
over the principal balance of the Mortgage Loans sold. For the fiscal year ended
December 31, 1997, the Company sold $477.1 million of Mortgage Loans through
whole Mortgage Loan sales transactions. The Company did not sell any Mortgage
Loans through securitization during this period; however, substantially all of
the Mortgage Loans sold during this period were ultimately securitized by the
purchasers thereof. Ultimately, the Company plans to build an investment
portfolio by retaining selected Subprime Mortgage Loans. The Company, however,
intends to continue to sell to various Mortgage Loan investors for cash gains,
Prime Mortgage Loans, certain Subprime Mortgage Loans and Second Lien Mortgage
Loans originated or purchased by the Company. See "Business -- Industry
Developments." The sale of these Mortgage Loans is expected to generate current
income and cash flow to fund, in part, the Company's mortgage lending
operations. See "Risk Factors -- Risks Associated with Mortgage Lending
Operations."
MORTGAGE INVESTMENT PORTFOLIO
The Company will acquire and manage a portfolio of Mortgage Assets,
primarily composed of Subprime Mortgage Loans originated and purchased by the
Company and financed with structured debt instruments. As with a bank or savings
and loan association, the Company's portfolio of Mortgage Assets is expected to
generate net income to the extent that the yield on its Mortgage Assets exceeds
the overall cost of its borrowings. The Company will attempt to construct a
portfolio of Mortgage Assets which will provide a relatively consistent level of
net interest income through a variety of interest rate environments. The Company
intends to develop and manage this portfolio of Mortgage Assets to maximize net
interest income within prescribed risk constraints. The Company has established
policies to manage the risks associated with its long-term investment in
Mortgage Assets. Such policies include capital and leverage, interest rate risk
management, credit risk management and prepayment risk management. See "Risk
Factors -- Risks Associated with a New Enterprise -- Risk of Future Revisions in
Policies and Strategies by Board of Directors."
STRUCTURED DEBT INSTRUMENTS
The Company intends to hold for long-term investment Subprime Mortgage
Loans originated or acquired by its mortgage lending operation and to finance
such Mortgage Loans with long-term financings through the issuance of structured
debt instruments, or collateralized mortgage obligations ("CMOs"). Under this
approach, for accounting purposes, the Mortgage Loans collateralizing any CMO
remain on the balance sheet as assets and the debt obligations (i.e., CMOs)
appear as liabilities. The Company's retained interest under this approach is
reflected by the excess of the assets over the related liabilities on its
balance sheet. The resulting stream of expected "spread" income will be
recognized over time through the proposed tax-advantaged REIT structure. The
Company does not intend to employ gain-on-sale securitizations as a financing
technique.
CAPITAL ALLOCATION GUIDELINES
The Company's goal is to maintain a balance between the under-utilization
of leverage, which may diminish returns to stockholders, and the
over-utilization of leverage, which could limit the Company's funding
alternatives during adverse market conditions. Therefore, the Company has
adopted Capital Allocation Guidelines ("CAG"). The primary factors influencing
the Company under circumstances of adverse market conditions are (i) increases
in interest rates, and (ii) increases in general market perception of credit
risk associated with residential Mortgage Loans. Interest rate increases reduce
the market value of the Company's Mortgage Assets and therefore reduce the
amount of available financing since financing is dependent on market values. An
increase in the perceived credit risk tends to increase the level of over-
collateralization required by rating agencies so that the Company can obtain
investment grade ratings on its senior classes of structured financings, such as
CMOs. Higher levels of over-collateralization reduce the quantity of total
financing prospectively available to the Company for a given quantity of
Mortgage Loans. The
5
<PAGE> 10
Company's CAG are designed for purposes of sustaining liquidity and funding
alternatives during each of these adverse market conditions.
SERVICING ACTIVITIES
During the period immediately following the closing of this Offering,
Advanta Mortgage Corp. ("Advanta") will provide subservicing for the Company
pursuant to the Loan Servicing Agreement, while management focuses on Mortgage
Loan production, Mortgage Loan processing, asset/liability management,
administrative operations and securitization. This subservicing agreement will
allow the Company to take advantage of the experience of Advanta's servicing
staff, their computer and customer service systems and collection procedure.
Although there can be no assurances, the Company intends to develop its own
servicing capability in order to oversee the performance of its Mortgage Loans
more directly and to manage the servicing relationship with its borrowers. The
timing of this action will be based on the time required to obtain the personnel
and computer systems necessary to properly manage a servicing department capable
of servicing over $1.0 billion in Subprime Mortgage Loans. Upon termination by
the Company of the subservicing agreement with Advanta, an unrelated publicly
held financial services company, the Company will incur certain termination
costs and fees. See "Business -- Servicing Activities."
STRUCTURE AND FORMATION TRANSACTIONS
STRUCTURE OF THE COMPANY
The Company will initially conduct its operations through at least two
entities as follows: (i) RealTrust Asset Corporation, a newly formed Maryland
corporation which will elect REIT status beginning with the taxable year ending
December 31, 1998 (for purposes of this discussion, sometimes referred to as
"RealTrust"), and (ii) CMG Funding Corp., a Delaware corporation which will not
elect REIT status (for purposes of this discussion, sometimes referred to as the
"Taxable Subsidiary"). This structure is designed primarily to permit RealTrust
to acquire the ownership of a substantial portion of the economic interest of
the Taxable Subsidiary while qualifying for REIT status. See "Federal Income Tax
Considerations -- Qualification as a REIT -- Nature of Assets" and "Risk
Factors -- Risks Associated with the Company's Combined Operations and this
Offering -- Potential Effects of 1999 Budget Plan."
6
<PAGE> 11
[STRUCTURE CHART]
FORMATION TRANSACTIONS
Immediately prior to or upon the closing of this Offering, the following
transactions (the "Formation Transactions") will be consummated:
- The stockholders of the Taxable Subsidiary will have contributed 95% of
their capital stock of the Taxable Subsidiary to RealTrust in exchange
for shares of RealTrust Capital Stock;
- The capital stock of the Taxable Subsidiary will be recapitalized such
that RealTrust will own non-voting preferred stock representing 95% of
the economic interest of the Taxable Subsidiary and the Founders will
own common stock representing five percent of the economic interest of
the Taxable Subsidiary;
- The outstanding shares of preferred stock of RealTrust, owned by
ContiFinancial Corporation, John Fry and Terry Mott, and all of the
shares of Common Stock of RealTrust held by the Founders will be
converted into an aggregate of 1,295,807 shares of Common Stock of
RealTrust, par value $.001 per share (the "Common Stock"); except the
410,581 shares of Class B Redeemable Preferred Stock owned by
ContiFinancial Corporation which will be redeemed after the closing of
this Offering (see "Certain Transactions -- ContiFinancial Corporation"
and "Use of Proceeds");
- The Company will amend its Articles of Incorporation to adopt provisions
necessary for qualification as a REIT;
- The Company will sell 5,000,000 Units in this Offering (assuming no
exercise of the Underwriters' over-allotment option); and
- The Company will grant the Representative's Warrants.
7
<PAGE> 12
Following the closing of this Offering, the following transactions will be
consummated (the "Post-Closing Transactions"):
- The Company will elect to be taxed as a REIT;
- The Company will conduct certain aspects of its mortgage lending
operations through the Taxable Subsidiary. The Company will own all of
the shares of non-voting preferred stock of the Taxable Subsidiary,
which shares shall represent 95% of the economic interest of the Taxable
Subsidiary. See "Risk Factors -- Risks Associated with the Company's
Combined Operations and this Offering -- Potential Effects of 1999
Budget Plan";
- The Founders will own all of the voting common stock of the Taxable
Subsidiary, which shares shall represent five percent of the economic
interest of the Taxable Subsidiary;
- The Company will redeem the 410,581 shares of Class B Redeemable
Preferred Stock held by ContiFinancial Corporation for $2,000,000, plus
dividends accrued since January 1, 1998, at the rate of 18% per annum;
and
- In addition to the options to purchase 37,526 shares of Common Stock
granted to officers, directors and employees, the Company will also
grant to officers, directors and employees (including ContiFinancial
Corporation) options to purchase an aggregate of 437,569 shares of
Common Stock under the 1998 Stock Option Plan.
The consummation of the Formation Transactions and the Post-Closing
Transactions will have the following consequences:
- The purchasers of Units in this Offering will own 79.4% of the
outstanding shares of Common Stock (assuming no exercise of the
Warrants, the Representative's Warrants, the over-allotment option or
outstanding stock options) and will own all of these Warrants, except
the Representative's Warrants;
- The Founders will collectively own 20.6% of the outstanding shares of
Common Stock outstanding (assuming no exercise of the Warrants, the
Representative's Warrants, the over-allotment option or outstanding
stock options);
- In addition to options granted to officers, directors and employees of
the Company to purchase 37,526 shares of Common Stock at an exercise
price of $7.33, officers, directors and employees of the Company
(including ContiFinancial Corporation) will have options to purchase an
aggregate of 437,569 shares of Common Stock, subject to certain vesting
provisions, at an exercise price equal to the Price to Public;
- The Company will own all of the non-voting preferred stock of the
Taxable Subsidiary, which shares will represent 95% of the economic
interest of the Taxable Subsidiary; and
- The Founders will own all of the voting shares of common stock of the
Taxable Subsidiary, which stock will represent five percent of the
economic value of the Taxable Subsidiary.
SUMMARY RISK FACTORS
Each prospective purchaser of the Units offered hereby should review the
"Risk Factors" beginning on page for a discussion of certain risk factors that
should be considered before acquiring the Units, including the following:
- Interest Rate Fluctuations; Impact on Operations and Net Interest
Income. To the extent the Company's cost of borrowings rises more
rapidly than the earnings on its Mortgage Assets, the Company's income
from operations may be reduced or eliminated.
- Increased Levels of Prepayments May Reduce Net Interest Income. In the
event that prepayments on the Company's Mortgage Assets exceed
expectations, the Company may (i) lose the opportunity to
8
<PAGE> 13
receive interest at the fully indexed rate, (ii) need to write-off
capitalized premium amounts and (iii) be unable to acquire new Mortgage
Assets to replace the prepaid Mortgage Assets.
- Limited Operating History of the Company and Net Losses. The Company
began operations in April, 1996, and therefore, the Company has not
developed an extensive earnings history. Although the Company has
generated monthly net profits since August, 1997, the Company has
experienced net losses for the fiscal years ended December 31, 1996 and
1997 and had an accumulated deficit of $3,080,177 as of December 31,
1997.
- Lack of Relevant Experience. The Company's management has had no prior
experience in managing a REIT.
- Failure to Achieve Optimal Degree of Leverage. The Company relies on
short-term borrowings to fund acquisitions of Mortgage Assets. Any
failure to obtain or renew adequate funding on favorable terms could
have a material adverse effect on the Company's operations. In such
event, the Company could be required to sell Mortgage Assets under
adverse market conditions and incur losses as a result. Neither the
Amended and Restated Articles of Incorporation nor the Bylaws restrict
the Company's level of borrowing.
- Potential Consequences of Failing to Effectively Hedge Against Interest
Rate Changes. Developing an effective interest rate risk management
strategy is complex and no strategy can completely insulate the Company
from the risks associated with unexpected interest rate changes. In
addition, the cost of hedging transactions and the federal tax laws
applicable to REITs may limit the Company's ability to fully hedge its
interest rate risks. Further, a provider of interest rate derivatives
may become financially unsound or insolvent, thereby rendering the
Company unprotected against interest rate risks.
- Higher Delinquency and Loss Rates with Subprime Mortgage
Borrowers. Subprime Mortgage Loans are made to borrowers who do not
qualify for Mortgage Loans that conform to FNMA and FHLMC guidelines
("Prime Mortgage Loans"), generally as a result of past derogatory
credit items. Thus, Subprime Mortgage Loans may result in increased
credit risk to the Company.
- Competition in the Subprime Mortgage Lending Market. The market for
Subprime Mortgage Loans is highly competitive and dynamic. As the
Company expands into particular geographic markets, it will face
increasing competition from larger lenders with substantially easier
access to capital and other resources than the Company. Continued
competition and the changing competitive environment may have a material
adverse effect on the Company's financial condition and its future
results of operation.
- Potential Effects of 1999 Budget Plan. Certain provisions of the
President's 1999 Budget Plan, if enacted, would adversely affect both
the Company's ability to conduct operations through the Taxable
Subsidiary and the Company's ability to qualify as a REIT for the fiscal
year ending December 31, 1998.
- Consequences of Failure to Maintain REIT Status; Company Subject to
Corporate Level Tax. If the Company fails to qualify as a REIT in any
taxable year, the Company may be subject to federal income tax as a
regular, domestic corporation, thereby significantly reducing or
eliminating the amount of cash available for distribution to its
stockholders. Failure to qualify for REIT status may reduce or eliminate
any advantage over non-REIT companies.
- Risk of Loss Resulting from Default. In the event of a default on any
Mortgage Loan held by the Company, the Company will bear the risk of
loss of principal and the Mortgage Loan will cease to be eligible
collateral for borrowings.
- Dependence on Key Personnel for Successful Operations. The Company's
operations depend in significant part upon the skills and experience of
Messrs. John D. Fry, Terry L. Mott, John P. McMurray and Steven K.
Passey. The loss of any such persons could have a material adverse
effect on the Company's business.
9
<PAGE> 14
- Risks Related to Economic Conditions. The Company's business may be
adversely affected by periods of economic slowdown or recession which
may be accompanied by declining real estate values.
- Illiquidity of Mortgage Assets. Certain of the Company's Mortgage Assets
may lack a regular trading market and, thus, may be illiquid. The
Company's inability to liquidate Mortgage Assets could render it
insolvent.
- Risk of Future Revisions in Policies and Strategies by Board of
Directors. The Board of Directors has established, but generally can
waive and modify, the investment and operating policies and strategies
of the Company. These policies and strategies do not limit the amount of
capital which may be invested in any one type of Mortgage Asset.
- Control by Management and Certain Affiliates; No Voting Control of the
Proposed Taxable Subsidiary. Upon the closing of this Offering, the
Company's directors and officers and certain affiliates thereof will
beneficially own or have a right to control approximately 20.6% of the
outstanding shares of Common Stock (assuming no exercise of the
Warrants, the Representative's Warrants, the over-allotment option or
outstanding employee stock options). As stockholders, they could exert
significant influence over corporate actions requiring stockholder
approval. Such officers and directors will also have voting control over
the Taxable Subsidiary and will control and direct its operations.
10
<PAGE> 15
DIVIDEND POLICY AND DISTRIBUTIONS
As a REIT, the Company must distribute substantially all of its taxable
income to stockholders during each year. See "Dividend Policy and Distributions"
and "Federal Income Tax Considerations -- Qualification as a
REIT -- Distributions." The Company expects to declare four regular dividends
each year commencing with a pro rata distribution for the quarter ending June,
1998. After the closing of this Offering, the Company intends to adopt a
Dividend Reinvestment Plan (the "DRP") that will allow stockholders to have
their dividends reinvested automatically in additional shares of Common Stock.
See "Dividend Reinvestment Plan."
THE OFFERING
<TABLE>
<S> <C>
Units Offered by the Company and Outstanding After This
Offering(1)............................................... 5,000,000
Common Stock to be Outstanding After This Offering(2)(3).... 6,295,807
Common Stock Purchase Warrants to be Outstanding After This
Offering(4)............................................... 5,000,000
Common Stock Options Outstanding After This Offering(5)..... 475,095
Use of Proceeds.............................. To fund, along with proceeds of Mortgage Loan sales
and financed borrowings, the Company's origination of,
and investment in, primarily Subprime Mortgage Loans;
to repay amounts borrowed under the working capital
finance facility with ContiFinancial Corporation; to
repay the Convertible Secured Promissory Note to
Capstone Investments, Inc.; to redeem shares of Class
B Redeemable Preferred Stock from ContiFinancial Cor-
poration; and as working capital to expand the
mortgage lending operations. Pending completion of the
purchase of such Mortgage Assets, the proceeds of the
Offering may be invested in short-term investments.
American Stock Exchange Symbol
For the Units............................................. RTA.U
For the Common Stock(6)................................... RTA
For the Warrants(6)....................................... RTA.W
</TABLE>
- ---------------
(1) Assumes the Underwriters' over-allotment option to purchase up to 750,000
additional Units is not exercised. Includes Units issuable upon exercise of
the option granted to Capstone Investments, Inc. to convert all or any
portion of a Convertible Secured Promissory Note into Units of the Company
offered hereby at the Price to Public. See "Certain Transactions -- Capstone
Investments, Inc."
(2) Does not include (i) 5,000,000 shares of Common Stock reserved for issuance
upon exercise of the Warrants which will be a part of the outstanding Units
(5,750,000 if the over-allotment option is exercised), or (ii) 150,000
shares of Common Stock reserved for issuance upon exercise of the
Representative's Warrants (172,500 if the over-allotment option is
exercised).
(3) Excludes the 410,581 shares of Class B Redeemable Preferred Stock owned by
ContiFinancial Corporation which will be redeemed after the closing of this
Offering. See "Certain Transactions -- ContiFinancial Corporation."
(4) Exercisable at the Price to Public. Excludes the Representative's Warrants.
The Warrants shall automatically detach from the Common Stock six months
after the closing of this Offering. Also excludes warrants granted to
ContiFinancial Corporation which terminate upon the closing of this Offering
and excludes warrants to purchase 50,000 shares of Common Stock at the Price
to Public granted to Capstone Investments, Inc. See "Certain
Transactions -- ContiFinancial Corporation" and " -- Capstone Investments,
Inc."
(5) Includes options to purchase 37,526 shares of Common Stock at an exercise
price of $7.33 per share granted under the 1996 Stock Option Plan and
options to purchase 437,569 shares of Common Stock at an exercise price
equal to the Price to Public granted under the 1998 Stock Option Plan. See
"Management -- Executive Compensation -- 1998 Stock Option Plan."
11
<PAGE> 16
(6) The Common Stock and Warrants will not be separately listed and traded until
the Warrants are detachable.
CERTAIN TRANSACTIONS
CONTIFINANCIAL CORPORATION
CMG Funding Corp., the Taxable Subsidiary, has entered into several
transactions with ContiFinancial Corporation. Certain obligations of the Taxable
Subsidiary will terminate upon closing of this Offering, and certain others will
be assumed by the Company and will continue after the closing of this Offering.
Stock Ownership. Immediately prior to the closing of this Offering,
ContiFinancial Corporation will own 546,883 shares of Common Stock, 252,117
shares of Class A Convertible Preferred Stock and 410,581 shares of Class B
Redeemable Preferred Stock, which in the aggregate represents approximately
43.0% of the outstanding shares of Capital Stock (approximately 42.0% on a fully
diluted basis). Immediately prior to the closing of this Offering, each share of
Class A Convertible Preferred Stock, including those owned by ContiFinancial
Corporation, will be converted into one share of Common Stock. All of the
outstanding shares of Common Stock will be reverse split into an aggregate of
1,295,807 shares of Common Stock. As a result, immediately prior to the closing
of this Offering, ContiFinancial Corporation will own 431,418 shares of Common
Stock, representing 33.3% of the outstanding shares (32.4% on a fully diluted
basis). Upon closing of this Offering, the Company intends to redeem the Class B
Redeemable Preferred.
The redemption price for all shares of the Class B Redeemable Preferred
Stock equals the original purchase price of $2,000,000, plus dividends accrued
from January 1, 1998 at the rate of 18% per annum, for a total redemption price
of $2,180,000, assuming redemption occurs on June 30, 1998. The Class B
Redeemable Preferred Stock is also entitled to a liquidation preference of
$2,000,000 plus accrued dividends. The Class B Redeemable Preferred Stock is not
convertible into Common Stock.
Agreements to Sell Mortgage Loans. Upon the closing of this Offering until
December 31, 2001, the Taxable Subsidiary has agreed to sell to ContiFinancial
Corporation not less than 75% of the fixed rate Subprime Mortgage Loans
originated or acquired by the Taxable Subsidiary in each month. The purchase
price for such Subprime Mortgage Loans shall be the fair market value for such
Mortgage Loans as determined by the best published rate sheet at ContiMortgage
Corporation, an affiliate of ContiFinancial Corporation. In any month, the
Taxable Subsidiary may substitute adjustable-rate Subprime Mortgage Loans for up
to 50% of the amount required to be offered for sale to ContiFinancial
Corporation. To the extent that the Taxable Subsidiary offers to sell less than
75% of the monthly fixed rate Subprime Mortgage Loan production, the Taxable
Subsidiary has agreed to pay ContiFinancial Corporation a fee equal to 40 basis
points multiplied by the amount of the principal shortfall.
Warehouse, Standby and Working Capital Financing Agreements. The Taxable
Subsidiary currently has a warehouse facility with ContiFinancial Corporation in
the principal amount of $50.0 million and a working capital facility in the
maximum principal amount of $2.0 million. As of February 28, 1998, the Company
had outstanding borrowings under such lines of $46.4 million and $1.8 million,
respectively. The Company anticipates that, immediately after the closing of
this Offering, the Company will repay all amounts borrowed under the working
capital facility. See "Use of Proceeds." The Taxable Subsidiary may continue to
finance the acquisition of Mortgage Loans under the warehouse facility. Although
the Company anticipates that it will be able to obtain financing more favorable
than the warehouse facility after the closing of this Offering, the Company
believes that the warehouse facility is currently on terms not less favorable to
the Company than those available from independent third parties in arm's-length
transactions.
Warrants to Purchase Capital Stock. The Taxable Subsidiary has granted to
ContiFinancial Corporation two warrants to purchase shares of common stock. If
the amount of principal and interest due under the working capital facility is
not repaid in full by January 1, 1999, the first warrant allows ContiFinancial
Corporation to purchase, for a nominal amount, shares of common stock
representing up to five percent of the outstanding shares (on a fully diluted
basis) of the Taxable Subsidiary. If the Company repays in full the working
capital facility, the warrant is not exercisable and automatically terminates.
The Company anticipates
12
<PAGE> 17
that the working capital facility will be repaid upon closing of this Offering
from the net proceeds thereof. See "Use of Proceeds."
The Taxable Subsidiary has also granted ContiFinancial Corporation a
warrant to purchase, for a nominal amount, shares of common stock representing
one percent of the outstanding shares (on a fully diluted basis) for each
quarter in which the Taxable Subsidiary does not attain at least 90% of its
pre-tax net income target. Such warrant automatically expires and may not be
exercised by ContiFinancial Corporation after the closing of this Offering. The
Taxable Subsidiary has established the pre-tax net income targets.
Structured Debt Placement Agent/Underwriter. Until December 2001, the
Company has appointed ContiFinancial Corporation as its exclusive placement
agent for structured debt offerings and other securitizations and has agreed to
pay to ContiFinancial Corporation a fee of 25 basis points of the principal
amount of any such structured debt public offering and 50 basis points of the
gross proceeds of any such structured debt private offering. Such fee is payable
to ContiFinancial Corporation for financial advisory services to be rendered
pursuant to the applicable contract and will not be reduced by any fees payable
or paid to others, including the underwriters, the placement agent or to other
agents or advisors, if any, in connection with any structured debt offering. See
"Certain Transactions -- ContiFinancial Corporation" and "Risk Factors -- Risks
Associated with the Acquisition and Management of a Portfolio of Mortgage Assets
-- Dependence Upon Structured Debt Financing Market and Credit Enhancements;
Potential Increased Cost of Agreement with ContiFinancial Corporation."
CAPSTONE INVESTMENTS, INC.
In March, 1998, the Taxable Subsidiary borrowed $850,000 from Capstone
Investments, Inc. ("Capstone"), a Nevada corporation, evidenced by a Convertible
Secured Promissory Note (the "Note") bearing simple interest at 9% per annum.
The Note matures upon the earlier of (i) January 1, 1999 or (ii) the closing of
this Offering. Interest on the Note is payable monthly and principal is payable
upon maturity. Founders David and Sarah Ferradino are the sole shareholders of
Capstone. Capstone has the option to convert all or any portion of the Note into
Units of the Company offered hereby at the Price to Public. In addition, the
Company has granted Capstone warrants to purchase 50,000 shares of common stock
at a price equal to the Price to Public. See "Certain Transactions -- Capstone
Investments, Inc."
13
<PAGE> 18
RISK FACTORS
In addition to the other information contained in this Prospectus, the
following risk factors should be carefully considered in evaluating the Company
and its business before purchasing any of the Units offered hereby. This
Prospectus contains forward-looking statements within the meaning of Section 27A
of the Securities Act. Discussions containing such forward-looking statements
may be found in the material set forth under "Prospectus Summary," "Use of
Proceeds," "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Business," as well as within the Prospectus
generally. Actual results could differ materially from those described in the
forward-looking statements as a result of the risks and uncertainties set forth
below and within the Prospectus generally. The Company cautions the reader,
however, that this discussion of risk factors may not be exhaustive.
GENERAL
The Company's mortgage lending operations and the proposed management of a
portfolio of Mortgage Assets involve numerous risk factors, many of which
overlap. For example, the risks associated with changes in interest rates affect
the mortgage lending business (e.g., by impacting the level of Mortgage Loan
originations) as well as the Mortgage Asset portfolio business (e.g., by
impacting the value of the Mortgage Assets and the prepayment rate and, hence,
the rate of amortization of premium and discount). In addition, both of the
Company's lines of business are subject to risks generally impacting the Company
as a whole, such as loss of REIT status for tax purposes. See "-- Risks
Associated with the Company's Combined Operations and this
Offering -- Consequences of Failure to Maintain REIT Status; Company Subject to
Corporate Level Tax."
The reader is cautioned, however, that the risk factors must be read in
their entirety for a full understanding of the Company's risk profile. It should
be noted that many of the risk factors discussed below apply to both lines of
business in different ways which could have offsetting effects on the Company's
combined businesses. For example, while increasing interest rates may lead to
reduced Mortgage Loan origination activity and related fees and a temporary
reduction in the Mortgage Asset portfolio's net interest income as interest
expense exceeds adjustable interest income, the effect of increasing rates on
the value of the Mortgage Loan servicing rights may be positive.
RISKS ASSOCIATED WITH A NEW ENTERPRISE
LIMITED OPERATING HISTORY OF THE COMPANY, NET LOSSES AND FAILURE TO ACHIEVE
PROJECTED LEVELS OF MORTGAGE LOAN ORIGINATIONS
The Company began mortgage lending operations in April, 1996. Accordingly,
the Company has not yet developed an extensive earnings history or experienced a
wide variety of interest rate or market conditions. Although the Company has
grown its Mortgage Loan origination volume significantly since the beginning of
operations, there can be no assurances that it will be able to successfully
operate its business as described in this Prospectus. Therefore, the Company's
historical operating performance may be of limited relevance in predicting
future performance.
The Company has generated monthly net profits since August, 1997, however,
the Company has experienced net losses for the fiscal years ended December 31,
1996 and 1997, and has an accumulated deficit of $3,080,177 as of December 31,
1997.
LACK OF RELEVANT EXPERIENCE
The Company's earnings will depend primarily upon management's ability to
acquire and manage a portfolio of Mortgage Assets, which is a new and unproven
business venture for the Company. Although the Company has originated, purchased
and underwritten both fixed and adjustable-rate Mortgage Loans and certain
officers have managed an investment portfolio of Mortgage Assets, none of the
officers or directors have experience in managing a REIT. See
"Management -- Directors and Executive Officers." There can be no assurance that
the Company will be able to successfully operate its business as described in
this Prospectus.
14
<PAGE> 19
If the Company does not originate or acquire a sufficient number of Mortgage
Loans, or if the management is unable to manage the risks of its Mortgage Loan
portfolio, the Company's business and results of operations will be materially
and adversely affected.
DEPENDENCE ON KEY PERSONNEL FOR SUCCESSFUL OPERATIONS
The Company's operations will depend heavily upon the contributions of
Messrs. John D. Fry, Terry L. Mott, John McMurray and Steven K. Passey, each of
whom would be difficult to replace. Although each of Messrs. Fry, Mott, McMurray
and Passey have signed employment agreements, and Messrs. Fry and Mott have
substantial equity stakes in the Company, there can be no assurance that they
will remain in the Company's employ. The loss of any of these individuals could
have a material adverse effect upon the Company's business and results of
operations. See "Management -- Executive Compensation -- Employment Agreements."
RISK OF FUTURE REVISIONS IN POLICIES AND STRATEGIES BY BOARD OF DIRECTORS
Management has established the Company's operating policies and strategies
as set forth in this Prospectus. However, these policies and strategies may be
modified or waived by the Board of Directors, subject in certain cases to
approval by a majority of the Independent Directors, without stockholder
approval. Ultimately, these changes may have a material adverse effect on the
Company's business, results of operations or financial condition.
NEED FOR ADDITIONAL CAPITAL TO SUPPORT FUTURE GROWTH; RISK OF POTENTIAL FUTURE
OFFERINGS
To implement fully the Company's strategy to continue rapid growth in its
portfolio of Mortgage Assets, the Company will be required to raise capital in
addition to the capital raised in this Offering. Accordingly, the Company
expects to increase its capital resources by making additional offerings of
equity and debt securities, which may include classes of preferred stock, common
stock, commercial paper, medium-term notes, mortgage-backed obligations and
senior or subordinated debt. There are no assurances that such additional
capital resources will be available on terms acceptable to the Company. In
addition, future equity offerings may dilute the equity of stockholders of the
Company or may reduce the value of shares of the Company's stock, or both. The
Company is unable to estimate the amount, timing or nature of additional
offerings as they will depend upon market conditions and other factors. There
can be no assurance that the Company will successfully or economically raise the
capital required to implement its business plan. If the Company is unable to
raise sufficient capital or raise capital on favorable terms, the Company's
business, results of operation and financial condition may be materially
adversely affected.
RISKS RELATED TO ECONOMIC CONDITIONS
The Company's business may be adversely affected by periods of economic
slowdown or recession which may be accompanied by decreased demand for consumer
credit and declining real estate values. Any material decline in real estate
values reduces the ability of borrowers to use home equity to support borrowings
and increases the loan-to-value ratios of Mortgage Loans previously made by the
Company, thereby weakening collateral coverage and increasing the possibility of
a loss in the event of default. Further, delinquencies, foreclosures and losses
generally increase during economic slowdowns or recessions. Because of the
Company's focus on borrowers who are unable or unwilling to obtain Mortgage
Loans from conventional mortgage sources, the actual rates of delinquencies,
foreclosures and losses on Subprime Mortgage Loans could be higher under adverse
economic conditions than those experienced in the conventional mortgage lending
industry. Any sustained period of such increased delinquencies, foreclosures and
losses would adversely affect the pricing of the Company's Mortgage Loan sales,
the rate paid to investors and the over-collateralization required on the
Company's long-term financing or whole loan sales. On the other hand, the
Company faces certain risks related to an improving economy, including, but not
limited to, the risk that during times of falling interest rates borrowers tend
to prepay their Mortgage Loans. "-- Risks Associated with the Acquisition and
Management of a Portfolio of Mortgage Assets -- Increased Levels of Prepayment
May Reduce Net Interest Income."
15
<PAGE> 20
RISKS ASSOCIATED WITH MORTGAGE LENDING OPERATION
INTEREST RATE FLUCTUATIONS; IMPACT ON OPERATIONS AND NET INTEREST INCOME
The Company's adjustable-rate Mortgage Assets bear interest at adjustable
or pass-through rates based on short-term interest rates, and substantially all
of the Company's borrowings bear interest at short-term rates and have
maturities of less than one year. Consequently, fluctuations in short-term
interest rates may significantly reduce the Company's net interest income. While
increases in short-term interest rates generally increase the yields on the
Company's adjustable-rate Mortgage Assets, rising short-term rates also increase
the debt service on the Company's borrowings which are utilized to fund the
Mortgage Assets. To the extent such debt service rises more rapidly than the
yields, the Company's net interest income may be reduced or a net loss may
result. Conversely, decreases in short-term interest rates may decrease the
yield on the Company's Mortgage Assets more rapidly than the interest costs on
the Company's borrowings and, hence, may decrease the Company's net interest
income. No assurance can be given as to the amount or timing of changes in
interest rates or their effect on the Company's Mortgage Assets or net interest
income. While the Company monitors the interest rate environment, seeks to earn
a positive spread between interest paid on borrowed funds and interest earned on
Mortgage Assets and employs a hedging strategy designed to mitigate the impact
of changes in interest rates, there can be no assurance that the profitability
of the Company would not be adversely affected during any period of fluctuations
in interest rates. See "-- Risks Associated with the Acquisition and Management
of a Portfolio of Mortgage Assets -- Potential Consequences of Failing to
Effectively Hedge against Interest Rate Changes."
A substantial or sustained increase in interest rates could adversely
affect the ability of the Company to originate and purchase Mortgage Loans and
would reduce the interest rate differential between newly originated Mortgage
Loans and the pass-through rate on Mortgage Loans that are financed.
Historically, interest rate increases have resulted in a reduction in the level
of re-financed Mortgage Loan originations. In such event, the Company's
origination volume may significantly decrease, prohibiting the Company from
acquiring or originating sufficient new Mortgage Loans to replace those Mortgage
Loans that are prepaid. In periods of declining production, the Company may be
required to purchase Mortgage Assets in the secondary market at higher costs,
thereby reducing earnings and income.
MORTGAGE ASSET COMMITMENT RISKS
The Company may issue commitments obligating it to purchase a specific
aggregate principal amount of Mortgage Assets from the holders of such
commitments from time to time during the commitment term. From the date the
price for the Mortgage Assets to be acquired by the Company is determined and
the date of delivery of such Mortgage Assets occurs, interest rates on
borrowings of the type to be used to finance the purchase of such Mortgage
Assets may rise. If the interest rates on the Mortgage Assets do not rise by a
corresponding amount and the Company's hedge against the commitments does not
perform as expected, the Company will nonetheless be required to purchase such
Mortgage Assets and such Mortgage Assets may produce a lower than anticipated
net income or a net loss, which could have a material adverse effect upon the
Company's results of operations.
AVAILABILITY OF FUNDING SOURCES; DEPENDENCE ON LENDERS
The Company finances substantially all of the Mortgage Loans which it
originates or acquires through interim financing facilities, including its
warehouse credit line and reverse repurchase agreements. See
"Business -- Capital and Liquidity Management." Historically, these borrowings
have been repaid with the proceeds received by the Company through Mortgage Loan
sales. See "-- Risks Associated with the Company's Combined Operations and this
Offering -- Potential Effects of 1999 Budget Plan." The Company is currently
dependent upon a few lenders to provide the primary credit facilities for its
Mortgage Loan originations and acquisitions. Any failure to renew or obtain
adequate funding under these financing arrangements, or any substantial
reduction in the size of, or pricing in, the market for the Company's Mortgage
Loans, could have a material adverse effect on the Company's operations.
Furthermore, the Company would not be able to hold a large volume of Mortgage
Loans pending structured debt financing, and,
16
<PAGE> 21
therefore, would have to curtail its Mortgage Loan production or sell Mortgage
Loans either through whole loan sales or through smaller structured debt
financing, potentially having a material adverse effect on the Company's results
of operations. Upon the sale of Mortgage Loans, the Company would terminate the
hedge positions associated with such Mortgage Loans, which could result in
further costs to the Company. A sharp rise in interest rates or increasing
market concern about the value or liquidity of a type or types of Mortgage
Assets being held by the Company will reduce the market value of the Mortgage
Assets, which may cause lenders to require additional collateral. A number of
such factors in combination may cause difficulties for the Company, including a
possible liquidation of a major portion of the Company's Mortgage Assets at
disadvantageous prices, which can cause losses and could have a material adverse
effect on the Company and its solvency.
RISK OF LOSS RESULTING FROM DEFAULT
Prior to completing a structured debt financing with respect to any
Mortgage Assets, the Company generally does not intend to obtain credit
enhancements such as mortgage pool or special hazard insurance for its Mortgage
Loans, other than Federal Housing Association ("FHA") insurance, Veterans
Association ("VA") guarantees and private mortgage insurance, in each case
relating only to individual Mortgage Loans. Accordingly, during the time it
holds such Mortgage Loans for which third-party insurance is not obtained, the
Company will be subject to risks of borrower defaults, bankruptcies and special
hazard losses that are not covered by standard hazard insurance (including,
without limitation, those occurring from earthquakes or floods). In the event of
a default on any Mortgage Loan held by the Company, including, without
limitation, resulting from declining property values and worsening economic
conditions, among other factors, the Company would bear the risk of loss of
principal to the extent of any deficiency between the market value of the
underlying real property, plus any payments from an insurer or guarantor, and
the amount owing on the Mortgage Loan. Defaulted Mortgage Loans would also cease
to be eligible collateral for borrowings and would have to be financed by the
Company out of other funds until ultimately liquidated, resulting in increased
financing costs and reduced net income or a net loss.
Credit risks associated with Subprime Mortgage Loans may be greater than
those associated with Prime Mortgage Loans. The principal difference between
Subprime Mortgage Loans and Prime Mortgage Loans include the applicable
loan-to-value ratios, the credit and income histories of the borrowers, the
documentation required for approval of the borrowers, the types of properties
securing the Mortgage Loans, Mortgage Loan sizes and the borrowers' occupancy
status with respect to the mortgaged property. As a result of these and other
factors, the interest rates charged on Subprime Mortgage Loans are often higher
than those charged for Prime Mortgage Loans. The combination of different
underwriting criteria and higher rates of interest may lead to higher
delinquency rates and/or credit losses for Subprime Mortgage Loans as compared
to Prime Mortgage Loans and could have an adverse effect on the Company to the
extent that the Company invests in such Mortgage Loans or securities secured by
such Mortgage Loans.
Many of the risks of holding Subprime Mortgage Loans and retaining, after
structured debt financing, a portion of the credit risk derived therefrom
reflect the risks of investing directly in the real estate securing the
underlying Mortgage Loans. This may be especially true in the case of a
relatively small or less diverse pool of Subprime Mortgage Loans. In the event
of a default on the underlying Mortgage Loan, the ultimate extent of the loss,
if any, may only be determined after a foreclosure of the Mortgage Loan
encumbering the property and, if the Company takes title to the property, upon
liquidation of the property. Factors such as title or the property's physical
condition (including environmental considerations) may make a third-party
unwilling to purchase the property at a foreclosure sale or for a price
sufficient to satisfy the obligations with respect to the related Mortgage
Loans. Foreclosure laws in various states may protract the foreclosure process.
In addition, the condition of a property may deteriorate during the pendency of
foreclosure proceedings. Moreover, certain Mortgage Loan borrowers may become
subject to bankruptcy proceedings, preventing the Company from immediately
liquidating the underlying real property. In each of the foregoing cases, the
amount and timing of amounts due to the Company may be materially adversely
affected.
17
<PAGE> 22
COMPETITION IN THE SUBPRIME MORTGAGE LENDING MARKET; CHANGES TO THE
COMPETITIVE ENVIRONMENT
As an originator and purchaser of Subprime Mortgage Loans, the Company will
face intense competition, primarily from commercial banks, savings and loans,
other independent mortgage lenders and certain other mortgage REITs. As the
Company expands into particular geographic markets across the nation, it will
face competition from lenders with established positions in these locations.
Many of the Company's competitors in the financial services business are
substantially larger and have more capital and other resources than the Company.
In addition, competition can take place on various other levels, including
convenience in obtaining a Mortgage Loan, service, marketing, origination
channels and pricing.
The Subprime Mortgage Loan market is currently undergoing substantial
changes. There are new entrants into the market, which is a changing competitive
environment. Furthermore, certain large national finance companies and Prime
Mortgage Loan originators have announced their intention to adapt their Prime
Mortgage Loan origination programs by allocating resources to the origination of
Subprime Mortgage Loans. Certain of these larger mortgage companies and
commercial banks have begun to offer products similar to those offered by the
Company and to target customers similar to those that the Company targets. For
example, FHLMC has announced its intention to make a secondary marketplace for
Subprime Mortgage Loans originated by certain financial institutions. The
entrance of these and other potential competitors into the Company's markets
could have a material adverse effect upon the Company's results of operations
and financial condition. In particular, the increasing level of capital
resources being devoted to Subprime Mortgage Loan lending may increase the
competition among lenders to originate or purchase Subprime Mortgage Loans and
result in either (i) reduced interest rates and, thus, compressed spreads on
such Mortgage Loans compared to present levels, which would decrease potential
profit margins, or (ii) revised underwriting standards permitting higher
loan-to-value ratios on properties securing Subprime Mortgage Loans, which would
increase the risk of loss in the event of default. There can be no assurance
that the Company will be able to compete successfully in this market environment
and any failure in this regard could have a material adverse effect on the
Company's results of operations and financial condition.
DEPENDENCE ON INDEPENDENT MORTGAGE BROKERS AND CORRESPONDENTS
The Company depends upon independent Mortgage Loan brokers and
correspondent lenders for a portion of its originations and purchases of new
Mortgage Loans. The Company has not entered into any exclusive arrangements with
independent brokers or correspondent lenders, who thus remain free to sell
Mortgage Loans to others. The Company competes with many other purchasers for
the correspondents' business based on pricing, service, loan fees, costs and
other factors. The Company's competitors also seek to establish relationships
with brokers and correspondents. The Company's future results may become more
exposed to fluctuations in the volume and cost of acquiring its Mortgage Loans
resulting from, among other things, competition from other prospective
purchasers of such Mortgage Loans.
ELIMINATION OF LENDER PAYMENTS TO BROKERS
Class action lawsuits have been filed against a number of mortgage lenders
alleging that such lenders have violated the Federal Real Estate Settlement
Procedures Act ("RESPA") by making certain payments to independent brokers.
These lawsuits have generally been filed on behalf of a purported nationwide
class of borrowers and allege that payments made by a lender to a broker in
addition to payments made by the borrower to a broker are prohibited by RESPA,
and are therefore illegal. In Culpepper v. Inland Mortgage Corporation, U.S.
Court of Appeals for the 11th Circuit, 1998 U.S. App. LEXIS 274 (January 9,
1998), the Court of Appeals determined that the payment of yield spread premiums
was an illegal referral fee. The Company has adopted disclosure requirements for
brokers as suggested by the Mortgage Bankers Association. While the Company has
been advised that such disclosure may mitigate the risk of claims, the Culpepper
decision may require the Company to change its broker compensation programs or
subject it to material monetary judgments or other penalties. Any such changes
or penalties may have a material adverse effect on the Company's results of
operations, financial condition or business prospects.
18
<PAGE> 23
RELIANCE ON SECONDARY MARKET PURCHASERS FOR MORTGAGE LOAN SALES
The Company plans to sell certain Mortgage Loans (primarily fixed-rate
Subprime Mortgage Loans, Prime Mortgage Loans and Second Lien Mortgage Loans) to
secondary market purchasers. See "-- Risk Associated with the Company's Combined
Operations and this Offering -- Potential Effects of 1999 Budget Plan" and
"Business -- Industry Developments." The Company's ability to manage its
Mortgage Loan portfolio according to its plan necessitates the existence of
purchasers for such Mortgage Loans. If the Company is unable to locate such
purchasers readily, it may affect the Company's ability to manage its Mortgage
Loan portfolio or may negatively affect the price at which the Company sells
such Mortgage Loans. Any such difficulty may have a material adverse effect on
the Company's results of operations, financial condition or business prospects.
LEGISLATION AND REGULATION
Members of Congress and government officials from time to time have
suggested the elimination of the mortgage interest deduction for federal income
tax purposes, either entirely or in part, based on borrower income, type of
Mortgage Loan or principal amount. Since many of the Company's Mortgage Loans
will be made to borrowers for the purpose of consolidating consumer debt or
financing other consumer needs, the competitive advantages of tax-deductible
interest, when compared with alternative sources of financing, could be
eliminated or seriously impaired by such government action. Accordingly, the
reduction or elimination of these tax benefits could have a material adverse
effect on the demand for the Mortgage Loans offered by the Company.
The Company's business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and will be
subject to various laws and judicial and administrative decisions imposing
requirements and restrictions on part or all of its operations. Regulated
matters include, without limitation, Mortgage Loan origination marketing
efforts, credit application and underwriting activities, maximum finance and
other charges, disclosure to customers, certain rights of rescission on Mortgage
Loans, closing and servicing Mortgage Loans, collection and foreclosure
procedures, qualification and licensing requirements for doing business in
various jurisdictions and other trade practices. Mortgage Loan origination
activities are subject to the laws and regulations in each of the states in
which those activities are conducted. Activities as a lender are also subject to
various federal laws including the Truth in Lending Act ("TILA"), the Equal
Credit Opportunity Act of 1974, as amended ("ECOA"), the Home Mortgage
Disclosure Act ("HMDA") and the Debt Collection Practices Act and the Fair
Credit Reporting Act. TILA and Regulation Z, issued under TILA, as amended,
contain disclosure requirements designed to provide consumers with uniform,
understandable information with respect to the terms and conditions of loans and
credit transactions in order to give them the ability to compare credit terms.
TILA also guarantees consumers a three-day right to cancel certain credit
transactions. TILA further imposes disclosure, underwriting and documentation
requirements on Mortgage Loans, known as "Section 32 loans," which are loans
with (i) total points and fees upon origination in excess of 8% of the Mortgage
Loan amount or (ii) an annual percentage rate of more than ten percentage points
higher than comparably maturing United States Treasury securities. The Company
is also required to comply with the ECOA, which prohibits creditors from
discriminating against applicants on the basis of race, color, sex, age or
marital status. Regulation B interpreting ECOA restricts creditors from
obtaining certain types of information from loan applicants. It also requires
certain disclosures by the lender regarding consumer rights and requires lenders
to advise applicants of the reasons for any credit denial. In instances where
the applicant is denied credit or the rate or charge for a Mortgage Loan
increases as a result of information obtained from a consumer credit agency, the
Fair Credit Reporting Act of 1970, as amended, requires the lender to supply the
applicant with the name and address of the reporting agency.
The Company will also be subject to the RESPA and will be required to file
an annual report with the Department of Housing and Urban Development ("HUD")
pursuant to the HMDA. The Company will also be subject to the rules and
regulations of, and examinations by, GNMA, HUD and state regulatory authorities
with respect to originating, processing, underwriting, selling and servicing
Mortgage Loans. Failure to comply with these requirements can lead to loss of
approved status, termination or suspension of servicing contracts
19
<PAGE> 24
without compensation to the servicer, demands for indemnifications or Mortgage
Loan repurchases, certain rights of rescission for Mortgage Loans, class action
lawsuits and administrative enforcement actions. There can be no assurance that
the Company will maintain compliance with these requirements in the future
without additional expenses, or that more restrictive local, state or federal
laws, rules and regulations will not be adopted or that existing laws and
regulations will not be interpreted in a more restrictive manner, which would
make compliance more difficult for the Company.
The laws and regulations described above are subject to legislative,
administrative and judicial interpretation, and certain of these laws and
regulations have been infrequently interpreted or only recently enacted.
Infrequent interpretations of these laws and regulations or an insignificant
number of interpretations of recently enacted regulations can result in
ambiguity with respect to permitted conduct under these laws and regulations.
Any ambiguity under the regulations to which the Company is subject may lead to
regulatory investigations or enforcement actions and private causes of action,
such as class action lawsuits, with respect to the Company's compliance with the
applicable laws and regulations. As a mortgage lender, the Company will be
subject to regulatory enforcement actions and private causes of action from time
to time with respect to its compliance with applicable laws and regulations.
ENVIRONMENTAL LIABILITIES
Certain properties securing Mortgage Loans may be contaminated by hazardous
substances. As a result, the value of the real property may be diminished. In
the event that the Company is forced to foreclose on a defaulted Mortgage Loan
on such a property, the Company may be subject to environmental liabilities
regardless of whether the Company was responsible for the contamination. While
the Company intends to exercise due diligence to discover potential
environmental liabilities prior to the acquisition of any such property through
foreclosure, hazardous substances or wastes, contaminants, pollutants or sources
thereof (as defined by state and federal laws and regulations) may be discovered
on properties during the Company's ownership or after a sale thereof to a
third-party. If such hazardous substances are discovered on a property, the
Company may be required to remove those substances or sources and clean-up the
property. The Company may also be liable to tenants and other users of
neighboring properties. In addition, the Company may find it difficult or
impossible to sell the property prior to or following any such clean-up. Any
exposure to environmental liability could have a material adverse effect on the
Company's results of operations or financial condition.
RISKS ASSOCIATED WITH THE ACQUISITION AND MANAGEMENT OF A PORTFOLIO OF MORTGAGE
ASSETS
OPERATIONS RISK
Although the Company hedges certain aspects of its interest rate risk, the
results of the Company's Mortgage Assets portfolio operation is affected by
various factors, many of which are difficult to predict or are beyond the
control of the Company. The performance of the Company's Mortgage Assets
portfolio depends on, among other things, the level of net interest income
generated by the Company's Mortgage Assets, the market value of such Mortgage
Assets, credit losses on Mortgage Assets held and the supply of, and demand for,
such Mortgage Assets. The Company's net interest income varies primarily as a
result of changes in short-term interest rates, borrowing costs and prepayment
rates, the behavior of which involve various risks and uncertainties as set
forth below. Prepayment rates, interest rates, borrowing costs and credit losses
depend upon the nature and terms of the Mortgage Assets, the geographic location
of the properties securing the Mortgage Loans included in or underlying the
Mortgage Assets, conditions in financial markets, the fiscal and monetary
policies of the United States government and the Board of Governors of the
Federal Reserve System, international economic and financial conditions,
competition and other factors, none of which can be predicted with any
certainty. Because changes in interest rates may significantly affect the
Company's activities, the operating results of the Company depend, in large
part, upon the ability of the Company to effectively manage its interest rate
and prepayment risks while maintaining its status as a REIT. See "-- Potential
Consequences of Failing to Effectively Hedge Against Interest Rate Changes,"
"-- Consequences Associated with Hedging," and "-- Risks of Substantial Leverage
and Potential Losses in Connection with Borrowings -- Counterparty Risks."
20
<PAGE> 25
DEPENDENCE ON STRUCTURED DEBT FINANCING MARKET AND CREDIT ENHANCEMENTS;
POTENTIAL INCREASED COST OF AGREEMENT WITH CONTIFINANCIAL CORPORATION
The Company intends to pool and finance through structured debt financing a
substantial portion of the Mortgage Loans it acquires or originates. The Company
may be required in such financings to continue to bear some risk of loss on the
underlying Mortgage Loans. Adverse changes in the structured debt financing
market could impair the Company's ability to originate, acquire and finance
Mortgage Loans through financings on a favorable or timely basis. Any such
impairment could have a material adverse effect upon the Company's results of
operations or financial condition. In addition, in order to gain access to the
structured debt financing market, the Company generally expects to rely upon
credit enhancements provided by one or more monoline insurance carriers. Any
substantial reductions in the size or availability of the structured debt
financing market for the Company's Mortgage Loans, or the unwillingness of
insurance companies to provide credit enhancement for the Company's Mortgage
Securities could have a material adverse effect upon the Company's results of
operations or financial condition.
Until December 2001, the Company has appointed ContiFinancial Corporation
as its exclusive placement agent for structured debt offerings and other
securitizations and has agreed to pay a placement agent fee of 25 basis points
of the principal amount of any such structured debt on public offerings and 50
basis points of the gross proceeds of any such private offering. Such fees are
payable to ContiFinancial Corporation for financial advisory services to be
rendered and will not be reduced by any fees payable or paid to others,
including the underwriters, placement agent or to other agents or advisors, if
any, in connection with any structured debt offering. The Company will depend
upon ContiFinancial Corporation to structure and sell to investors structured
debt financings. If the fees payable to ContiFinancial Corporation are higher
than those available from third parties, the Company's earnings and
distributions may be materially reduced. See "Certain
Transactions -- ContiFinancial Corporation."
EFFECT OF BORROWINGS ON PORTFOLIO MANAGEMENT
In the event the Company is unable to renew or replace maturing borrowings,
the Company could be required to sell Mortgage Loans under adverse market
conditions and could incur losses as a result. See "-- Risks Associated with the
Company's Combined Operations and this Offering -- Potential Effects of 1999
Budget Plan." Furthermore, it would not be able to hold a large volume of
Mortgage Loans pending structured debt financing and, therefore, would have to
curtail its Mortgage Loan production or sell Mortgage Loans either through whole
loan sales or through securitizations, thereby having a material adverse effect
on the Company's results of operations. In addition, in such event, the Company
may be required to terminate hedge positions, which could result in further
costs to the Company. A sharp rise in interest rates or increasing market
concern about the value or liquidity of a type or types of Mortgage Loans being
held by the Company will reduce the market value of the Mortgage Loans, which
may cause lenders to require additional collateral. At the same time, the market
value of the Mortgage Assets in which the Company's capital is invested may
decrease. A number of such factors in combination may cause difficulties for the
Company, including possible liquidation of a major portion of the Company's
Mortgage Loans at disadvantageous prices with consequent losses, which could
have a material adverse effect on the Company and its solvency.
POTENTIAL EFFECTS OF DIFFERENCES BETWEEN MORTGAGE ASSET AND BORROWING
CHARACTERISTICS
A substantial portion of all Mortgage Assets are expected to have
adjustable terms or are fixed initially, but have interest rate indices that
will adjust at some point in the future. Interest rates on the Company's
borrowings are, and generally will be, based on short-term indices. To the
extent any of the Company's Mortgage Assets are financed with borrowings bearing
interest based on, or varying with, an index different from that used for the
related Mortgage Assets, so-called "basis" interest rate risk will arise. In
such event, if the index used for the Mortgage Assets is a "lagging" index (such
as the 11th District Cost of Funds) that reflects market interest rate changes
on a delayed basis, and the rate borne by the related borrowings reflects market
rate changes more rapidly, the Company's net interest income will be adversely
affected in periods of increasing market interest rates.
21
<PAGE> 26
Additionally, the Company's adjustable-rate Mortgage Assets will be subject
to periodic rate adjustments which may be more or less frequent than the
increases or decreases in rates borne by the borrowings or financings utilized
by the Company. Accordingly, in a period of increasing interest rates, the
Company could experience a decrease in net interest income or a net loss because
the interest rates on borrowings could adjust faster than the interest rates on
the Company's Adjustable-Rate Mortgage Loans ("ARMs") or Mortgage Assets backed
by ARMs. Moreover, ARMs are typically subject to periodic and lifetime interest
rate caps which limit the amount an ARM's interest rate can change during any
given period. The Company's borrowings will not be subject to similar
restrictions. Hence, in a period of rapidly increasing interest rates, the
Company could also experience a decrease in net interest income or a net loss in
the absence of effective hedging because the interest rates on borrowings could
increase without limitation while the interest rates on the Company's ARMs and
Mortgage Assets backed by ARMs would be limited by caps. Furthermore, some ARMs
may be subject to periodic payment caps that result in some portion of the
interest accruing on the ARM being deferred and added to the principal
outstanding. This could result in receipt by the Company of less cash income on
its ARMs than the debt service that the Company is required to pay on the
related borrowings, which will not have such payment caps. The Company expects
that the net effect of these factors, all other factors being equal, will be to
lower the Company's net interest income or cause a net loss during periods of
rapidly rising market interest rates (but not necessarily in an environment of
gradually rising market interest rates), which could negatively impact the level
of dividend distributions and the market price of the Common Stock. Conversely,
in periods of declining market interest rates, the Company's net interest income
may be initially increased, but following a lag period the Company's income and
levels of dividend distributions may be reduced.
INCREASED LEVELS OF PREPAYMENT MAY REDUCE NET INTEREST INCOME
Prepayment rates vary from time to time and may cause changes in the amount
of the Company's net interest income. Prepayments of ARMs and Mortgage Assets
backed by ARMs usually can be expected to increase when mortgage interest rates
fall below the then-current interest rates on such ARMs and decrease when
mortgage interest rates exceed the then-current interest rate on the ARMs,
although such effects are not predictable. Prepayment experience also may be
affected by the geographic location of the property securing the Mortgage Loans,
the assumability of the Mortgage Loans, conditions in the housing and financial
markets and general economic conditions. In addition, prepayments on ARMs are
affected by the ability of the borrower to convert an ARM to a fixed-rate
Mortgage Loan and by conditions in the fixed-rate Mortgage Loan market. If the
interest rates on ARMs increase at a rate greater than the interest rates on
fixed-rate Mortgage Loans, prepayments on ARMs may tend to increase. In periods
of fluctuating interest rates, interest rates on ARMs may exceed interest rates
on fixed-rate Mortgage Loans, which may tend to cause prepayments on ARMs to
increase at a rate greater than anticipated. Mortgage Securities backed by
Mortgage Loans are often structured so that certain classes are provided
protection from prepayments for a period of time. However, in a period of
extremely rapid prepayments, during which earlier-paying classes may be retired
faster than expected, the protected classes may receive unscheduled payments of
principal earlier than expected and would have average lives that, while longer
than the average lives of the earlier-paying classes, would be shorter than
originally expected. The Company will seek to minimize prepayment risk through a
variety of means, including structuring a diversified portfolio of Mortgage
Assets with a variety of prepayment characteristics, originating and investing
in Mortgage Assets with prepayment prohibitions and penalties, investing in
certain Mortgage Security structures which have prepayment protection, and
balancing Mortgage Assets purchased at a premium with Mortgage Assets purchased
at a discount. In addition, the Company may in the future purchase interest-only
strips to a limited extent. However, no strategy can completely insulate the
Company from prepayment risks arising from the effects of interest rate changes.
There is also further uncertainty about prepayment rates on Subprime
Mortgage Loans since there is less information and historical data than exists
for Prime Mortgage Loans. Certain Mortgage Assets may consist of Mortgage Loans
that are, and Mortgage Securities evidencing interests in, ARMs convertible to
fixed-rate Mortgage Loans. Because converted Mortgage Loans are required to be
repurchased by the applicable Agency or servicer, the conversion of a Mortgage
Loan results, in effect, in the prepayment of such Mortgage Loan.
22
<PAGE> 27
The Company acquires the majority of its Mortgage Assets at a premium over
face amount. For financial reporting purposes, these premiums are amortized as
an adjustment to the yield of the acquired Mortgage Asset. During periods of
increasing interest rates, borrowers are more likely to refinance Mortgage
Loans. As Mortgage Loans are prepaid, premiums may be amortized faster than
originally expected. Sudden rises in interest rates may increase prepayments,
which would cause a significant portion of premiums to be amortized, resulting
in a significant negative impact on net interest income or result in a net loss.
Although many of the Mortgage Loans originated by the Company have penalties for
prepayment, certain Mortgage Loans originated and Mortgage Loans acquired from
third-party correspondents may not have prepayment penalties, thereby increasing
the Company's exposure to prepayment risks.
Changes in anticipated prepayment rates of Mortgage Assets could affect the
Company in several adverse ways. A portion of the ARMs acquired by the Company
will have been recently originated and will still bear initial interest rates
which are lower than their "fully-indexed" rates (the applicable index, plus a
margin). In the event that such an ARM is prepaid faster than anticipated, such
as prior to or soon after the time of adjustment to a fully-indexed rate, the
Company will have experienced an adverse effect on its net interest income
during the time it held such ARM (compared with holding a fully-indexed ARM) and
will have lost the opportunity to receive interest at the fully-indexed rate
over the expected life of the ARM. In addition, the faster than anticipated
prepayment of any Mortgage Asset that had been purchased at a premium by the
Company would generally result in a faster than anticipated write-off of any
remaining capitalized premium amount and consequent reduction of the Company's
net interest income by such amount.
HIGH LOAN-TO-VALUE PRODUCTS
The Company's current underwriting guidelines allow for the acquisition of
Mortgage Loans with up to a 90% loan-to-value ratio ("LTV"). See
"Business -- Underwriting and Quality Control Strategies." The higher the LTV,
the greater the risk that the Company may be unable to recover full amounts due
on its Mortgage Loans in the event the borrower defaults and the Company
forecloses and sells the underlying collateral. The failure of the Company to
adequately address the risk of high LTV Mortgage Loan products would have a
material adverse effect on the Company's results of operations and financial
condition.
HIGHER DELINQUENCY AND LOSS RATES WITH SUBPRIME MORTGAGE BORROWERS
Lenders in the Subprime Mortgage Loan banking industry make Mortgage Loans
to borrowers who have impaired or limited credit histories, limited
documentation of income and higher debt-to-income ratios than traditional
mortgage lenders or Prime Mortgage Loan lenders allow. Thus, Subprime Mortgage
Loans generally entail a higher risk of delinquency and foreclosure than Prime
Mortgage Loans and may result in higher levels of realized loss. A large portion
of the Company's Mortgage Loans are made to borrowers who do not qualify for
Mortgage Loans from conventional Mortgage Loan lenders. For the year ended
December 31, 1997, approximately 2.73% and .57% of the Company's Subprime
Mortgage Loan purchases and originations were comprised of Mortgage Loans made
to borrowers graded "C" or "C-" respectively, the Company's two lowest credit
grade classifications. See "Business -- Underwriting and Quality Control
Strategies." No assurances can be given that the Company's underwriting criteria
or methods will afford adequate protection against the higher risks associated
with Mortgage Loans made to Subprime Mortgage Loan borrowers. The failure of the
Company to adequately address the risk of Subprime Mortgage Loan lending would
have a material adverse impact on the Company's results of operations, financial
condition or business prospects.
POTENTIAL CONSEQUENCES OF FAILING TO EFFECTIVELY HEDGE AGAINST INTEREST RATE
CHANGES
The Company's operating strategy subjects it to interest rate risks as
described under "-- Risks Associated with Mortgage Lending Operation -- Interest
Rate Fluctuations; Impact on Operations and Net Interest Income" above. The
Company follows an asset/liability management strategy intended to protect
against interest rate changes and prepayments. See "Business -- Interest Rate
Risk Management." Nevertheless, developing an effective asset/liability
management strategy is complex and no strategy can completely insulate the
Company from risks associated with interest rate changes and prepayments. In
addition, there can be no assurance that the Company's hedging activities will
have the desired beneficial impact on the
23
<PAGE> 28
Company's results of operations or financial condition. Hedging typically
involves costs, including transaction costs, which increase dramatically as the
period covered by the hedge increases and which also increase during periods of
rising and volatile interest rates. The Company may increase its hedging
activity, and, thus, increase its hedging costs, during such periods when
interest rates are volatile or rising and hedging costs have increased.
Moreover, federal tax laws applicable to REITs may substantially limit the
Company's ability to engage in certain asset/liability management transactions.
Such federal tax laws may prevent the Company from effectively implementing
particular hedging strategies that the Company determines, absent such
restrictions, would best insulate the Company from the risks associated with
changing interest rates and prepayments. See "Federal Income Tax
Considerations -- Taxation of the Company."
CONSEQUENCES ASSOCIATED WITH HEDGING
The Company intends to purchase interest rate caps, interest rate swaps and
other appropriate financial instruments to mitigate the risk of the interest
cost of its variable rate liabilities increasing at a faster rate than the
earnings on its Mortgage Assets during a period of rising rates. In this way,
the Company intends generally to hedge as much of the interest rate risk as
management determines is in the best interests of the Company given the cost of
such hedging transactions and the need to maintain the Company's status as a
REIT. In this regard, the amount of income the Company may earn from its hedging
is subject to limitation under the REIT provisions of the Code. The Company may
hedge the risk of its borrowing costs on its liabilities increasing faster than
its income, due to the effect of the periodic and lifetime caps on its Mortgage
Assets, through the acquisition of (i) Qualified REIT Assets, such as
interest-only REMIC regular interests, that function in a manner similar to
hedging instruments, (ii) Qualified Hedges, the income from which qualifies for
the 95% income test, but not the 75% income test for REIT qualification
purposes, and (iii) other hedging instruments, whose income qualifies for
neither the 95% income test nor the 75% income test. See "Federal Income Tax
Considerations -- Qualification as a REIT -- Sources of Income." The latter form
of hedging may be accomplished through the Taxable Subsidiary. See
"Business -- Industry Developments," "Business -- Interest Rate Risk Management"
and "Federal Income Tax Considerations -- Taxation of the Company." The Company
may attempt to increase its overall yield by saving the cost of acquiring and
carrying hedging instruments by not hedging certain periodic interest rate
adjustments when the Company determines, based on all relevant facts, that
bearing such risk is advisable and does not present an unacceptable risk.
However, there can be no assurance that the Company's estimation of the risks
will be accurate and failure to hedge appropriately may effect the Company's
results of operations.
POTENTIAL EFFECT OF THE COMPANY'S OWNING SUBORDINATED CLASSES OF DEBT
Some of the Mortgage Securities that the Company retains from its CMO
financings may be subordinated Mortgage Securities that are not supported by
credit enhancements, are not rated and have limited liquidity. To the extent
third parties have been contracted to provide the credit enhancement, the
Company is dependent in part upon the creditworthiness and the ability of the
insurer to pay claims and the timeliness of reimbursement in the event of a
default on the underlying obligations. The insurance coverage for various types
of losses is limited in amount and, consequently, losses in excess of the
limitation would be borne by the Company.
CONTINGENT AND RESIDUAL RISKS IN STRUCTURED DEBT FINANCINGS
In connection with any structured debt financings the Company may
undertake, the Company anticipates that it will be required to repurchase or
substitute Mortgage Loans in the event of a breach of representation or warranty
made by the Company. While the Company may have recourse to the sellers of
Mortgage Loans it purchased, there can be no assurance of the seller's abilities
to honor their respective obligations to the Company. Likewise, in connection
with any whole loan sales made by the Company, the Company will enter into
agreements which generally will require the Company to repurchase or substitute
Mortgage Loans in the event of a breach of a representation or warranty made by
the Company to the Mortgage Loan purchaser, any misrepresentation during the
Mortgage Loan origination process or, in some cases, upon any fraud or early
default on such Mortgage Loans. The remedies available to a purchaser of
Mortgage Loans from the
24
<PAGE> 29
Company may be generally broader than those available to the Company against the
sellers of such Mortgage Loans. If a purchaser enforces its remedies against the
Company, the Company may not be able to enforce whatever remedies the Company
may have against its sellers. During the period of time that the Mortgage Loans
are held by the Company, the Company is subject to the various business risks
associated with the lending business, including borrower default, foreclosure
and the risk that a rapid increase in interest rates would result in a decline
in the value of Mortgage Loans held for sale to potential purchasers. To the
extent the Company maintains an interest in structured debt financings backed by
Mortgage Loans it acquires or originates, the Company retains some degree of
prepayment, credit, default and interest rate risk.
In addition, borrowers, purchasers of the Company's Mortgage Loans,
monoline insurance carriers and trustees in any structured debt financing
undertaken by the Company may make claims against the Company arising from (i)
alleged breaches of fiduciary obligations, misrepresentations, errors and
omissions of employees, officers and agents of the Company, including
appraisers, (ii) incomplete documentation, and (iii) failure by the Company to
comply with various laws and regulations applicable to its business. Any claims
asserted in the future may result in liabilities or legal expenses that could
have a material adverse effect on the Company's results of operations, financial
conditions and business prospects.
ILLIQUIDITY OF MORTGAGE ASSETS
A substantial portion of the Company's portfolio may be in the form of
Mortgage Securities for which the secondary trading market is not as well
developed as the market for certain other Mortgage Securities (or which are
otherwise considered less marketable or illiquid). In addition, the Company may
invest in Mortgage Securities which have been sold in private placements and
have not been registered under the Securities Act. Unregistered Mortgage
Securities may be subject to restrictions on resale which may limit the ability
of the Company to sell them when it might be most desirable to do so. Although
the Company expects that most of the Company's investments will be in Mortgage
Securities for which a resale market exists, certain of the Company's Mortgage
Assets may lack a regular trading market and may be illiquid. In addition,
during turbulent market conditions, the liquidity of all of the Company's
Mortgage Assets may be adversely impacted. There is no limit in the percentage
of the Company's investments that may be invested in Mortgage Assets that become
illiquid.
RISK OF LACK OF GEOGRAPHIC DIVERSIFICATION
The Company seeks geographic diversification of the properties underlying
its Mortgage Assets and has originated Mortgage Loans in more than 25 states.
Nevertheless, properties underlying such Mortgage Assets may be located in the
same or a limited number of geographical regions. To the extent that properties
underlying such Mortgage Assets are located in the same geographical region,
such Mortgage Assets may be subject to a greater risk of default than other
comparable, geographically dispersed Mortgage Assets in the event of adverse
economic, political or business developments and natural hazard risks in such
region and, ultimately, the ability of property owners to make payments of
principal and interest on the underlying Mortgage Loans.
RISKS ASSOCIATED WITH SERVICING
The Company intends initially to contract for the servicing of all Mortgage
Loans it originates, purchases and holds to maturity with a third-party mortgage
servicer pursuant to an interim servicing agreement. See "Business -- Servicing
Activities." In addition, a third-party mortgage servicer will subservice each
structured debt financing of the Company's Mortgage Loans pursuant to a related
pooling and servicing agreement and a corresponding subservicing agreement
between the Company and the third-party servicer. As with any external service
provider, the Company is subject to risks associated with insufficient or
untimely services. Many of the Company's borrowers will require notices and
reminders to keep their Mortgage Loans current and to prevent delinquencies and
foreclosures. Any failure of the subservicer to adequately service the Company's
Mortgage Loans could cause a substantial increase in the Company's delinquency
or foreclosure rates, which could adversely effect the Company's ability to
access equity or debt capital resources.
25
<PAGE> 30
Ultimately, inadequate or ineffective servicing could have a material adverse
effect on the Company's results of operations, financial condition and business
prospects.
RISKS OF SUBSTANTIAL LEVERAGE AND POTENTIAL LOSSES IN CONNECTION WITH BORROWINGS
FAILURE TO ACHIEVE OPTIMAL DEGREE OF LEVERAGE
The Company employs a financing strategy to increase the size of its
Mortgage Asset portfolio by borrowing a substantial portion (which may vary
depending upon the mix of the Mortgage Assets in the Company's portfolio and the
application of the Company's CAG with respect to such mix of Mortgage Assets) of
the market value of its Mortgage Assets. If the returns on the Mortgage Assets
purchased with borrowed funds fail to cover the cost of the borrowings, the
Company will experience net interest losses. In addition, through increases in
haircuts (i.e., the equity capital required by a lender or purchaser to finance
the Company's Mortgage Assets), decreases in the market value of the Company's
Mortgage Assets, increases in interest rate volatility, availability of
financing in the market, circumstances then applicable in the lending market and
other factors, the Company may not be able to achieve the degree of leverage it
believes to be optimal, which may cause the Company to be less profitable than
it might be otherwise.
FAILURE TO REFINANCE OUTSTANDING BORROWINGS
Additionally, the ability of the Company to achieve its investment
objectives depends not only on its ability to borrow money in sufficient amounts
and on favorable terms but also on the Company's ability to renew or replace on
a continuous basis its maturing short-term borrowings. The Company's business
strategy relies on warehouse facilities and short-term reverse repurchase
agreements to fund Mortgage Loan originations and purchases. See
"Business -- Capital and Liquidity Management." In the event the Company is not
able to renew or replace maturing borrowings, the Company could be required to
sell Mortgage Assets under adverse market conditions and could incur losses as a
result. See "Business -- Industry Developments." In addition, in such event, the
Company may be required to terminate hedge positions, which could result in
further costs to the Company. An event or development such as a sharp rise in
interest rates or increasing market concern about the value or liquidity of a
type or types of Mortgage Assets in which the Company's Mortgage Loan portfolio
is concentrated will reduce the market value of the Mortgage Assets, which would
likely cause lenders to require additional collateral. At the same time, the
market value of the Mortgage Assets in which the Company's liquid capital is
invested may have decreased. A number of such factors in combination may cause
difficulties for the Company, including a possible liquidation of a major
portion of the Company's Mortgage Asset portfolio at disadvantageous prices with
consequent losses, which could have a material adverse effect on the Company and
its solvency.
EFFECT OF DECLINE IN MARKET VALUE OF MORTGAGE ASSETS; MARGIN CALLS
A decline in the market value of the Company's portfolio of Mortgage Assets
may limit the Company's ability to borrow or result in lenders initiating margin
calls (i.e., requiring a pledge of cash or additional Mortgage Assets to
re-establish the ratio of the amount of the borrowing to the value of the
collateral). This remains true despite effective hedging against such
fluctuations because the hedging instruments may not be part of the collateral
securing the collateralized borrowings. Additionally, it may be difficult to
realize the full value of the hedging instrument when desired for liquidity
purposes due to the applicable REIT provisions of the Code. See "Federal Income
Tax Considerations -- Qualification as a REIT -- Sources of Income -- The 95%
Test." The Company could be required to sell Mortgage Assets under adverse
market conditions in order to maintain liquidity. See "Business -- Industry
Developments." Such sales may be effected by management when deemed by it to be
necessary in order to preserve the capital base of the Company. If these sales
were made at prices lower than the amortized cost of the Mortgage Assets, the
Company would experience losses. A default by the Company under its
collateralized borrowings could also result in a forced liquidation of
collateral, including any cross-collateralized assets, and resulting in a loss
equal to the difference between the value of the collateral and the amount
borrowed.
26
<PAGE> 31
COUNTERPARTY RISKS
In the event that the Company purchases interest rate caps or other
interest rate agreements to hedge against lifetime and periodic rate or payment
caps, and the provider of interest rate agreements becomes financially unsound
or insolvent, the Company may be forced to unwind its interest rate agreements
with such provider and may take a loss on such interest rate agreements due to
counterparty default or due to the Company's decision to unwind the agreement
based on the financial soundness instead of the general economic reasons.
Although the Company intends to purchase interest rate agreements from
financially sound institutions and to monitor the financial strength of such
institutions on a periodic basis, no assurance can be given that the Company can
avoid such third-party risks.
POTENTIAL CONSEQUENCES OF BANKRUPTCY
Additionally, in the event of a bankruptcy of the Company, certain reverse
repurchase agreements may qualify for special treatment under the Bankruptcy
Code, the effect of which is, among other things, to allow the creditors under
such agreements to avoid the automatic stay provisions of the Bankruptcy Code
and to liquidate the collateral under such agreements without delay. Conversely,
in the event of the bankruptcy of a party with whom the Company had a reverse
repurchase agreement, the Company might experience difficulty recovering the
collateral subject to such agreement if the agreement were to be repudiated and
the Company's claim against the bankrupt lender for damages resulting therefrom
were to be treated simply as one of an unsecured creditor. Should this occur,
the Company's claims would be subject to significant delay and recoveries, if
and when received, and may be substantially less than the damages actually
suffered by the Company. Although the Company has, and intends to continue to,
enter into reverse repurchase agreements with several different parties and has
developed policies to reduce its exposure to such risks, no assurance can be
given that the Company will be able to avoid such third-party risks.
RISKS ASSOCIATED WITH THE COMPANY'S COMBINED OPERATIONS AND THIS OFFERING
ABSENCE OF A PUBLIC TRADING MARKET; FLUCTUATIONS IN MARKET PRICE
There has not been a public market for the Securities prior to this
Offering. Accordingly, there can be no assurance that a liquid trading market
for the Securities offered hereby will develop or, if developed, that the market
will be sustained. In the absence of a public trading market, an investor may be
unable to liquidate his investment in the Company. The Price to Public was
determined by the Company and the Underwriter. See "Underwriting." There can be
no assurance that the price of the Units in the public market after the closing
of this Offering will not be lower than the Price to Public. While there can be
no assurance that a market for the Company's Securities will develop, the
Company intends to apply for listing of the Units, the Common Stock and the
Warrants on the American Stock Exchange.
If a public market for the Securities exists, it is likely that the market
price of the Securities will be influenced by any variation between the net
yield on the Company's Mortgage Assets and prevailing market interest rates.
However, earnings will not necessarily be greater in high interest rate
environments than in low interest rate environments. Moreover, in periods of
high interest rates, the net earnings of the Company, and, therefore, the
dividend yield on the Common Stock, may be less attractive compared with
alternative investments, which could negatively impact the price of the
Securities. If the anticipated or actual net yield on the Company's Mortgage
Assets declines or if prevailing market interest rates rise, thereby decreasing
the positive spread between the net yield on such investments and the cost of
the Company's borrowings, the market price of the Securities may be adversely
affected.
CONSEQUENCES OF FAILURE TO MAINTAIN REIT STATUS; COMPANY SUBJECT TO CORPORATE
LEVEL TAX
The Company intends, for the fiscal year ending December 31, 1998, and all
times thereafter, to operate so as to qualify as a REIT for federal income tax
purposes. In order to maintain its qualification as a REIT for federal income
tax purposes, the Company must satisfy certain tests with respect to the sources
of its income, the nature and diversification of its assets, the amount of its
distributions to stockholders and the ownership of its Capital Stock. See
"Federal Income Tax Considerations -- Qualification as a REIT -- Distributions."
If
27
<PAGE> 32
the Company fails to qualify as a REIT in any taxable year and certain relief
provisions of the Code do not apply, the Company would be subject to federal
income tax as a regular, domestic corporation for four subsequent years, and its
stockholders would be subject to tax in the same manner as stockholders of such
a corporation. Distributions to stockholders in any year in which the Company
fails to qualify as a REIT, including the fiscal year 1998, would not be
deductible by the Company in computing its taxable income. As a result, the
Company could be subject to income tax liability, thereby significantly reducing
or eliminating the amount of cash available for distribution to its
stockholders. Further, the Company could also be disqualified from re-electing
REIT status for the four taxable years following the year during which it became
disqualified.
POTENTIAL EFFECTS OF 1999 BUDGET PLAN
Certain provisions in the President's 1999 Budget Plan, if enacted, would
adversely affect both the Company's ability to conduct operations through the
Taxable Subsidiary and the Company's ability to qualify as a REIT for the fiscal
year ended December 31, 1998. The President's 1999 Budget Plan, as presented to
Congress on February 2, 1998, contains several provisions which affect REITs.
One such provision, if enacted, could have a potentially adverse effect on the
way that the Company intends to operate its mortgage conduit operations. That
provision would prohibit a REIT from owning, by vote or value, more than 10% of
the stock of another corporation. The rules currently in place for REIT
compliance limit (i) a REIT to owning less than 10% of the outstanding voting
securities of another corporation and (ii) the value of a REIT's ownership of
the securities of any one issuer to less than five percent of the value of the
REIT's assets. See "Federal Income Tax Considerations -- Qualification as a
REIT -- Nature of Assets". By limiting a REIT's ownership of the securities of
another corporation to 10% of the value of the issuing corporation, the
proposal, if enacted, could force the Company to have to divest itself of most
of the preferred stock of the Taxable Subsidiary that the Company currently owns
or terminate activities in the Taxable Subsidiary that would be prohibited
activities by a REIT, including, but not limited to, the origination of Mortgage
Loans for sale. In such an event the Company would not receive the dividends
that the Company expects to earn from the Taxable Subsidiary, which could have a
material adverse effect on the Company's net profits after such divestiture. See
"Business -- Industry Developments" and "Federal Income Tax
Considerations -- Recent Legislative Proposals." In addition, in the event the
Company could no longer engage in Mortgage Loan sales, the Company would be
unable to fulfill its contractual obligation to sell certain fixed-rate Mortgage
Loans to ContiFinancial Corporation. See "Certain Transactions -- ContiFinancial
Corporation." If the Company fails to sell to ContiFinancial 75% of the
Company's fixed-rate Mortgage Loan production, the Company has agreed to pay
ContiFinancial a fee equal to 40 basis points multiplied by the principal amount
of the shortfall. Such payment would materially reduce the earnings and
distributions of the Company.
In addition, if the 1999 Budget Plan is adopted with a retroactive date of
application, and after the effective date a quarterly REIT test date has
occurred, the Company will not be able to qualify as REIT for 1998. See
"Business -- Industry Developments." As a result, the Company would be taxed as
a "C" corporation for 1998, and would be subject to corporate level tax on all
of its net earnings. In such an event, the anticipated dividends and
distributions of the Company would be materially reduced.
Further, the 1999 Budget Plan, if adopted as proposed, would result in the
recognition by the Company of tax on the built-in gain on its assets. Under
current law, a "C" corporation may be acquired by or converted into a REIT on a
tax-free basis. If the REIT makes the appropriate election, the tax on the
built-in gain (the difference between (a) the purchase price for the "C"
corporation or the fair market value of the "C" corporation's stock and (b) the
adjusted tax basis of the "C" corporation's assets) would only be imposed if the
REIT disposed of an asset of the acquired corporation within 10 years after the
acquisition of the "C" corporation. The 1999 Budget Plan would treat the
acquisition of a "C" corporation by a REIT as a taxable liquidation by the "C"
corporation to its shareholders followed by a deemed contribution of the "C"
corporation's assets to the REIT. Such treatment would result in corporate level
tax to the "C" corporation in the amount of the built-in gain on the "C"
corporation's assets followed by shareholder level tax to the extent that the
value of the assets deemed distributed from the "C" corporation to its
shareholders exceeds the shareholders' tax basis in their stock in the "C"
corporation. The 1999 Budget Plan proposes that such changes would first be
effective for years beginning after January 1, 1999.
28
<PAGE> 33
Adoption of the 1999 Budget Plan could have a material adverse effect on
the Company's operations and profitability. No assurance can be given that
future legislation, regulations, administrative interpretations or court
decisions will not significantly change the tax laws with respect to the
Company's qualification as a REIT or the federal income tax consequences of such
qualification, which changes may reduce or eliminate the Company's competitive
advantage over non-REIT competitors. See "Federal Income Tax
Considerations -- Qualification as a REIT" and "Federal Income Tax
Considerations -- Taxation of the Company."
CONSEQUENCES OF FAILURE TO QUALIFY FOR EXEMPTION FROM INVESTMENT COMPANY ACT
The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act of
1940, as amended (the "Investment Company Act"). Accordingly, the Company does
not expect to be subject to the restrictive provisions of the Investment Company
Act. The Investment Company Act exempts entities that are "primarily engaged in
the business of purchasing or otherwise acquiring mortgages and other liens on
and interests in real estate" ("Qualifying Interests"). Under the current
interpretation of the staff of the Commission, in order to qualify for this
exemption, the Company must maintain at least 55% of its assets directly in
Mortgage Loans, qualifying Pass-Through Certificates and certain other
qualifying interests in real estate. In addition, unless certain Mortgage Assets
owned by the Company represent all the certificates representing economic
interests issued with respect to an underlying pool of Mortgage Loans, such
Mortgage Assets may be treated as securities separate from the underlying
Mortgage Loans and, thus, may not qualify as Qualifying Interests for purposes
of the 55% safe harbor. Therefore, the Company's ownership of certain Mortgage
Assets may be limited by the provisions of the Investment Company Act. If the
Company fails to qualify for exemption from registration as an investment
company, its ability to use leverage would be substantially reduced and it would
be unable to conduct its business as described herein. Any such failure to
qualify for such exemption could have a material adverse effect on the Company.
ISSUANCE OF PREFERRED STOCK
Subject to the limitations set forth in the Amended and Restated Articles
of Incorporation, the Board of Directors is authorized to reclassify any of the
unissued shares of authorized capital stock into a class or classes of preferred
stock. The issuance of additional preferred stock could have the effect of
making an attempt to gain control of the Company more difficult by means of a
merger, tender offer, proxy contest or otherwise. The additional preferred
stock, if issued, could have a preference on dividend payments over the Common
Stock which could affect the ability of the Company to make dividend
distributions to the holders of Common Stock. Further, the shares of preferred
stock may be entitled to preferential liquidation, voting and other rights which
could have a material adverse effect on the value of the Company's other
Securities.
RESTRICTIONS ON OWNERSHIP OF CAPITAL STOCK
In order that the Company may meet the requirements for qualification as a
REIT at all times, the Amended and Restated Articles of Incorporation prohibit
any person from acquiring or holding, directly or indirectly, shares of Capital
Stock in excess of 9.8% in value of the aggregate of the outstanding shares of
Capital Stock or in excess of 9.8% (in value or in number of shares, whichever
is more restrictive) of the aggregate of the outstanding shares of Common Stock
of the Company. For this purpose, the term "ownership" is defined in accordance
with REIT provisions of the Code and the constructive ownership provisions of
Section 544 of the Code, as modified by Section 856(h)(1)(B) of the Code. Under
such rules, for example, certain types of entities such as widely-held
corporations may hold in excess of the 9.8% limit because shares held by such
entities are attributed to such entities' stockholders. Conversely, shares of
Capital Stock owned or deemed to be owned by a person who individually owns less
than 9.8% of the shares outstanding may nevertheless be in violation of the
ownership limitations set forth in the Amended and Restated Articles of
Incorporation if, under certain circumstances, shares owned by others (such as
family members) are attributed to such individual. See "Federal Income Tax
Considerations -- Qualification as a REIT -- Ownership of Stock." The Amended
and Restated Articles of Incorporation further prohibit (i) any person from
beneficially or constructively owning shares of Capital Stock that would result
in the Company
29
<PAGE> 34
being "closely held" under Section 856(h) of the Code or otherwise cause the
Company to fail to qualify as a REIT, and (ii) any person from transferring
shares of Capital Stock if such transfer would result in shares of Capital Stock
being owned by fewer than 100 persons.
Subject to certain limitations, the Board of Directors may increase or
decrease the ownership limitations. In addition, to the extent consistent with
the REIT provisions of the Code, the Board of Directors may waive the ownership
limitations for and at the request of certain purchasers in this Offering. The
provisions described above may inhibit market activity and the resulting
opportunity for the holders of the Company's Capital Stock and Warrants to
receive a premium for their Securities that might otherwise exist in the absence
of such provisions. Such provisions also may make the Company an unsuitable
investment vehicle for any person seeking to obtain ownership of more than 9.8%
of the outstanding shares of Capital Stock.
CONTROL BY MANAGEMENT AND CERTAIN AFFILIATES; NO VOTING CONTROL OF THE PROPOSED
TAXABLE SUBSIDIARY; POTENTIAL CONFLICTS OF INTEREST
Upon the closing of this Offering, the Company's directors and officers and
certain affiliates thereof will beneficially own or have a right to control
approximately 20.6% of the outstanding shares of Common Stock of the Company
(assuming no exercise of the Warrants, the Representative's Warrants or the
over-allotment option). As stockholders, they could exert significant influence
over corporate actions requiring stockholder approval.
The Company originates those Mortgage Loans which it intends to sell
through the Taxable Subsidiary. See "-- Potential Effects of 1999 Budget Plan"
and "Business -- Industry Developments." The Taxable Subsidiary will not qualify
as a Qualified REIT Subsidiary under the Code and will, therefore, be subject to
corporate tax. The Company ultimately will own 95% of the economic value of the
Taxable Subsidiary, but will not own any voting securities. All voting power
will be held by the Founders. As a result, the Company will not control the
management or operations of the Taxable Subsidiary. Because the Founders, and
not the Company, will own or control the voting stock of the Taxable Subsidiary,
the Founders may direct the business and operations of the Taxable Subsidiary in
a manner inconsistent with the best interests of the Company and its
stockholders.
30
<PAGE> 35
THE COMPANY
RealTrust Asset Corporation is a newly formed Maryland corporation
incorporated on [April 1, 1998]. The Taxable Subsidiary, CMG Funding Corp., was
organized in February, 1996 as a mortgage banking company located in Salt Lake
City, Utah. The Taxable Subsidiary now has 14 branch offices located in 12
states which originated or purchased approximately $507.4 million in
single-family residential Mortgage Loans during the calendar year ended December
31, 1997.
The Company intends to avail itself of the federal income tax advantages of
electing REIT status for the tax year ending December 31, 1998, subject to the
discussion under "Business -- Industry Developments" and "Risk
Factors -- Potential Effects of 1999 Budget Plan." The Company must distribute
to its stockholders on a pro rata basis each year an amount equal to 95% of its
taxable income before deduction of dividends paid and excluding net capital
gain, plus (ii) 95% of the excess of the net income from foreclosure property
over the tax imposed on such income by the Code, less (iii) any "excess noncash
income." See "Dividend Policy and Distributions." The Company intends to make
distributions to its stockholders in amounts sufficient to meet these 95%
distribution requirements. In any year in which the Company qualifies as a REIT,
it generally will not be subject to federal income tax on that portion of its
taxable income or net capital gain which is distributed to its stockholders. See
"Federal Income Tax Considerations."
The Company will manage its portfolio of Mortgage Assets. The Company
conducts its mortgage lending business through the Taxable Subsidiary. See
"Business -- Industry Developments." The Company owns all of the issued and
outstanding shares of non-voting preferred stock of the Taxable Subsidiary which
entitles the Company to 95% of the economic value of the Taxable Subsidiary. The
Founders of the Company own all of the issued and outstanding shares of voting
common stock of the Taxable Subsidiary which entitle them to voting control but
only five percent of the economic value of the Taxable Subsidiary. The Taxable
Subsidiary will not be consolidated with the Company for accounting purposes
because the Company will not own any of the Taxable Subsidiary's voting common
stock, and thus, the Company will not control the Taxable Subsidiary.
As a REIT, the Company will be self-advised and self-managed. Management of
the Company conducts the day-to-day operations of the Company, subject to the
direction of the Board of Directors. The Company's offices are located at 2855
East Cottonwood Parkway, Suite 500, Salt Lake City, Utah 84121, and its
telephone number is (801) 365-3000.
USE OF PROCEEDS
The net proceeds of this Offering, assuming a Price to Public of $15.00 per
Unit, are estimated to be $68,900,000 ($79,362,500 if the Underwriters'
over-allotment option is exercised). The net proceeds will be used to provide an
equity base for owning a portfolio of Mortgage Assets, to fund the origination
and purchase of Mortgage Loans through the Taxable Subsidiary's mortgage lending
operation, to expand the Mortgage Loan production capacity, to repay the
outstanding balance on the working capital credit facility, to redeem shares of
Class B Redeemable Preferred Stock held by ContiFinancial Corporation, to repay
the Convertible Secured Promissory Note to Capstone Investments, Inc., and for
general working capital and other corporate purposes. Pending use of the net
proceeds of this Offering for such purposes, the net proceeds will be invested
in Mortgage Assets acquired in the secondary mortgage market. The Company
intends to increase its investment in Mortgage Assets by borrowing against
existing Mortgage Assets and using the net proceeds to acquire additional
Mortgage Assets. The Company's borrowings generally will be secured by the
Mortgage Assets owned by the Company. Until the Company has fully implemented
this financing strategy and increased its Mortgage Asset investments to the
desired level, the net earnings on the Company's portfolio of Mortgage Assets
are expected to be lower than would be the case if the investment strategy were
fully implemented promptly after the closing of this Offering.
31
<PAGE> 36
The following table sets forth certain information concerning the estimated
use of the gross proceeds of this Offering:
<TABLE>
<CAPTION>
PERCENTAGE OF
AMOUNT TOTAL FUNDS
----------- -------------
<S> <C> <C>
Estimated Offering Expenses:
Underwriting Discount(1)............................. $ 5,250,000 7.0%
Offering Expenses(2)................................. $ 850,000 1.1%
Funding of Mortgage Loan Originations and Purchases of
Mortgage Assets(3)...................................... $59,300,000 79.1%
Repayment of Working Capital Credit Facility(4)........... $ 2,100,000 2.8%
Repayment of Debt(5)...................................... $ 850,000 1.1%
Redemption of Preferred Stock and Accrued Dividends(4).... $ 2,180,000 2.9%
Working Capital and Other Corporate Purposes.............. $ 4,470,000 6.0%
----------- -----
Gross Offering Proceeds(6)................................ $75,000,000 100.0%
=========== =====
</TABLE>
- ---------------
(1) The underwriting discount is seven percent, plus Representative's Warrants
to acquire, at the Price to Public, a number of Warrant Shares equal to
three percent of the number of Units sold.
(2) This amount consists of estimated legal, accounting, printing and other
expenses of this Offering, and organizational expenses, which have been or
will be paid by the Company.
(3) See "Business."
(4) See "Certain Transactions -- ContiFinancial Corporation."
(5) See "Certain Transactions -- Capstone Investments, Inc."
(6) Assumes no exercise of the Underwriter's over-allotment option.
DIVIDEND POLICY AND DISTRIBUTIONS
Commencing with the 1998 fiscal year, the Company generally intends to
distribute substantially all of its taxable income each year (which does not
ordinarily equal net income as calculated in accordance with GAAP) to its
stockholders so as to comply with the REIT provisions of the Code. The Company
intends to make dividend distributions quarterly. Any taxable income remaining
after the distribution of the final regular quarterly dividend each year is
distributed together with the first regular quarterly dividend payment of the
following taxable year or in a special dividend distributed prior thereto. The
dividend policy is subject to revision at the discretion of the Board of
Directors. All distributions will be made by the Company at the discretion of
the Board of Directors and will depend on the taxable income of the Company, the
financial condition of the Company, maintenance of REIT status and such other
factors as the Board of Directors deems relevant. See "Federal Income Tax
Considerations -- Qualification as a REIT -- Distributions."
Distributions to stockholders will generally be subject to tax as ordinary
income, although a portion of such distributions may be designated by the
Company as capital gain or may constitute a tax-free return of capital. The
Company generally does not intend to declare dividends that would result in a
return of capital to any substantial degree. The Company will annually furnish
to each of its stockholders a statement setting forth distributions paid during
the preceding year and their characterization as ordinary income, capital gains,
or return of capital. For a discussion of the Federal income tax treatment of
distributions by the Company, see "Federal Income Tax Considerations -- Taxation
of the Company's Stockholders."
DIVIDEND REINVESTMENT PLAN
The Company anticipates that, after the closing of this Offering, it will
adopt a dividend reinvestment plan ("DRP") for stockholders who wish to reinvest
their distributions in additional shares of Capital Stock. The DRP will be
administered by American Securities Transfer & Trust Incorporated which will
maintain records, prepare and send out statements to all participants, provide
safe-keeping for the shares purchased
32
<PAGE> 37
under the DRP and perform other duties related to the DRP. Generally, under a
DRP, dividends paid with respect to shares of Capital Stock are automatically
invested in additional shares of Common Stock at a discount to the then current
market price. Such discount will be determined, from time to time, by the Board
of Directors consistent with the requirements to qualify as a REIT. The DRP will
also allow each stockholder to make additional investments in Common Stock by
contributing cash to the DRP administrator (up to a specified maximum).
Stockholders will not be automatically enrolled in the DRP.
DILUTION
As of December 31, 1997, there were 1,295,807 shares of the Company's
Common Stock outstanding (on a pro forma basis after giving effect to the
Formation Transactions, other than the issuance and sale of the Units offered
hereby, and the Post-Closing Transactions and the net tangible book value of the
Company was $1,104,005), having a net tangible book value per share of Capital
Stock of approximately $0.85. Net tangible book value per share represents the
amount of the Company's total tangible assets less its total liabilities,
divided by the number of shares of its Capital Stock outstanding.
After giving effect to the net proceeds from the sale of Units offered
hereby at the Price to Public of $15.00 per Unit and the proceeds from the
exercise of the Warrants and the Representative's Warrants, assuming no exercise
of the Underwriters' over-allotment option, the pro forma net tangible book
value of the Company as of December 31, 1997 would have been $145,254,005 or
$12.69 per share. This represents a dilution of $2.31 per share to new investors
purchasing Units at $15.00 per Unit.
<TABLE>
<CAPTION>
PER SHARE
---------
<S> <C> <C>
Price to Public per Unit................................. $15.00
Dilution attributable to underwriting discount and
offering expenses................................. $(1.22)
Dilution attributable to Formation Transactions..... $(2.98)
Accretion attributable to exercise of the Warrants
and the Representative's Warrants................. $ 1.89
------
Book value per share after underwriting discount and
offering expenses, Formation Transactions, accretion
for the Warrants and the Representative's Warrants..... $12.69
======
</TABLE>
The following table summarizes, on a pro forma basis as of December 31,
1997, after giving effect to the Formation Transactions, the difference between
the existing stockholders and the investors in this Offering with respect to the
number of shares of Common Stock (assuming no exercise of the Underwriters'
over-allotment option, the Warrants or the Representative's Warrants) purchased
from the Company, the total consideration paid and the average price per share:
<TABLE>
<CAPTION>
SHARES OF THE COMPANY TOTAL CONSIDERATION
---------------------- ---------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- -------- ----------- ------- -------------
<S> <C> <C> <C> <C> <C>
Existing stockholders............... 1,295,807 20.6% $ 2,542,408(1) 3.3% $ 1.96
New investors(2).................... 5,000,000 79.4% $75,000,000 96.7% $15.00
--------- ----- ----------- -----
Total.......................... 6,295,807 100.0% $77,542,408 100.0% $12.32
========= ===== =========== =====
</TABLE>
- ---------------
(1) Reflects the capital contributions to CMG Funding Corp. by each of the
Founders, except the $2.0 million paid by ContiFinancial Corporation for its
410,581 shares of Class B Redeemable Preferred Stock, which will be redeemed
after the closing of this Offering for the purchase price plus accrued
dividends at 18% per annum, for a total price of $2.18 million, assuming
redemption occurs on June 30, 1998.
(2) Assumes no exercise of the Warrants, the warrants granted to Capstone
Investments, Inc., the Representative's Warrants or the Underwriters'
over-allotment option.
33
<PAGE> 38
CAPITALIZATION
The table below sets forth the capitalization of the Company, as of
December 31, 1997 and as adjusted to reflect the issuance of the Units offered
in this Offering at a Price to Public of $15.00 per Unit and the application of
the estimated net proceeds therefrom as described under "Use of Proceeds."
<TABLE>
<CAPTION>
DECEMBER 31, 1997
-----------------------------
AS
ACTUAL ADJUSTED(1)(2)
----------- --------------
<S> <C> <C>
STOCKHOLDERS' EQUITY:
Class A Convertible Preferred Stock, par value $0.001
per share; 1,268,950 shares authorized; 1,263,472
shares issued and outstanding; As Adjusted: 5,000,000
shares authorized; no shares issued and
outstanding(3)....................................... $ 1,263 $ -0-
Common Stock, par value $.001 per share; 2,609,407
authorized; 1,546,983 shares issued and outstanding;
As adjusted: 100,000,000 shares authorized; 6,295,807
shares issued and outstanding........................ 1,547 6,296
Additional paid-in capital.................................. 4,539,598 71,436,112
Accumulated deficit......................................... (3,080,177) (3,080,177)
----------- -----------
Total Stockholders' Equity........................ $ 1,462,231 $68,362,231
=========== ===========
</TABLE>
- ---------------
(1) After deducting the underwriting discount of seven percent and estimated
offering expenses of $850,000 payable by the Company.
(2) Assumes the sale of 5,000,000 Units in this Offering but that none of the
Underwriters' over-allotment option, the Warrants, the warrants granted to
Capstone Investments, Inc. or the Representative's Warrants are exercised.
Excludes all options granted to officers, directors and employees of the
Company pursuant to the 1996 Stock Option Plan and the 1998 Stock Option
Plan. See "Management -- Executive Compensation -- 1996 Stock Option Plan;"
"-- 1998 Stock Option Plan."
(3) Does not include the 410,581 shares of Class B Redeemable Preferred Stock
held by ContiFinancial Corporation to be redeemed from the net proceeds of
this Offering. See "Certain Transactions -- ContiFinancial Corporation."
34
<PAGE> 39
SELECTED FINANCIAL DATA
The selected financial data presented below as of December 31, 1997 and
1996, and for the year ended December 31, 1997, and the period February 7, 1996
(date of inception) to December 31, 1996, respectively, are derived from the
financial statements of CMG Funding Corp., which financial statements have been
audited by KPMG Peat Marwick LLP, independent auditors, and the report thereon,
are included elsewhere in this Prospectus.
<TABLE>
<CAPTION>
PERIOD FROM
FEBRUARY 7, 1996
YEAR ENDED (DATE OF INCEPTION) TO
DECEMBER 31, 1997 DECEMBER 31, 1996
----------------- ----------------------
<S> <C> <C>
STATEMENT OF OPERATIONS DATA
Revenues:
Interest................................................ $ 3,756,870 $ 621,601
Gain-on-sale of mortgage loans, net..................... 5,967,647 446,771
Mortgage servicing fees................................. 38,826 --
Other................................................... 269,248 92,063
----------- -----------
Total revenues.................................. 10,032,591 1,160,435
----------- -----------
Expenses:
Salaries and Employee Benefits.......................... 4,474,357 390,018
General Operating....................................... 4,313,236 1,285,156
Interest................................................ 2,965,685 731,519
Other................................................... 53,624 59,608
----------- -----------
Total expenses.................................. 11,806,902 2,466,301
----------- -----------
Net loss................................................ $(1,774,311) $(1,305,866)
=========== ===========
BALANCE SHEET DATA:
Cash and cash equivalents................................. 708,962 272,308
Mortgage loans held for sale.............................. 54,451,067 24,147,713
Other assets.............................................. 3,707,274 938,031
----------- -----------
Total assets.................................... 58,867,303 25,358,052
=========== ===========
Warehouse and revolving working capital lines of credit... 55,603,021 23,996,471
Other liabilities......................................... 1,802,051 1,227,450
Total liabilities............................... 57,405,072 25,223,921
Stockholders' equity...................................... 1,462,231 134,131
----------- -----------
Total liabilities and stockholders' equity...... $58,867,303 $25,358,052
=========== ===========
</TABLE>
35
<PAGE> 40
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
As further discussed in other sections of this Prospectus, CMG Funding
Corp. has operated as a specialty finance company primarily engaged in
originating, purchasing, selling and servicing Prime Mortgage Loans and Subprime
Mortgage Loans. Subsequent to the closing of this Offering the Company intends
to build a portfolio of Mortgage Assets financed with structured debt
instruments while selling for cash gains, Prime Mortgage Loans, certain Subprime
Mortgage Loans and Second Lien Mortgage Loans. See "Business -- Industry
Developments." The Company intends to elect to be taxed as a REIT under the
Code, beginning with the tax year ending December 31, 1998 and, thus, expects
higher net earnings than traditional mortgage lending institutions which are
subject to federal income tax. The composition of the Company's earnings will
depend to a large degree on the spread income earned on the Company's Mortgage
Asset portfolio in future periods, and less so on the mortgage lending
activities the Company has conducted in the past and will continue to conduct in
the future. See "Business -- Industry Developments" and "Risk
Factors -- Potential Effects of 1999 Budget Plan."
CMG Funding Corp. funded its first Mortgage Loans in April, 1996. Prior to
the closing of this Offering, the Company generated revenue from the following
activities: (i) Mortgage Loan origination fees, (ii) cash gains from the sale of
Mortgage Loans, (iii) servicing income, and (iv) interest income from Mortgage
Loans prior to their sale. The Company has generated profits since August, 1997;
however, prior to such time, the Company's monthly expenses exceeded monthly
revenue. Such expenses were primarily to support rapid expansion of its
wholesale and retail branch network, and included salaries and benefits, general
operating expenses and debt service, among other expenses. Included in these
expense categories are the cost of certain computer and other equipment, the
purchase and creation of software systems and customary office costs which were
expensed in the current period.
After the closing of this Offering, the business focus of the Company will
change from generating income solely from mortgage banking activities to
generating income from the net interest income earned on a portfolio of Mortgage
Assets. In undertaking this new business focus, the Company has five principal
strategies: (i) to continue to increase Mortgage Loan originations through high
levels of service to independent brokers and borrowers in its wholesale and
retail channels, (ii) to expand correspondent mortgage lending activities, (iii)
to convert from selling all Mortgage Loan production to building a portfolio of
Subprime Mortgage Loans, (iv) to sell certain Mortgage Loans for cash gains (see
"Business -- Industry Developments"), and (v) elect to be taxed as a REIT under
the Code beginning with the tax year ending December 31, 1998. There can be no
assurance that the Company's strategies can be successfully implemented or that
such strategies will result in improved revenues and earnings.
CERTAIN ACCOUNTING POLICIES AND PROCEDURES
TAXABLE INCOME AND GAAP INCOME
Income as calculated for tax purposes ("taxable income") differs from
income as calculated according to generally accepted accounting principles
("GAAP income") for various reasons. Interest income differs due to different
methods of calculating the rate of amortization of the premium or discount when
Mortgage Assets are acquired at a price above or below the stated principal
amount of the Mortgage Loans. Credit losses differ between tax and GAAP methods
of accounting because the Company takes credit provisions in order to build a
credit allowance for GAAP whereas only actual credit losses are deducted in
calculating taxable income. General and administrative expenses differ due to
differing treatment of leasehold amortization and other items. Interest expense
is calculated in the same manner for GAAP and tax purposes.
These distinctions are important to the Company's stockholders since
dividends are based on taxable income. The Company generally will not pay
federal taxes so long as it meets the REIT provisions of the Code and
distributes dividends to stockholders in an amount equal to its taxable income.
See "Federal Income Tax Consequences -- Qualification as a REIT."
36
<PAGE> 41
TAXABLE INCOME AND DIVIDENDS
The Company intends to declare and pay dividends equal to its taxable
income over time. The Company's current practice is to declare quarterly
dividends per share immediately following the regular March, June, September and
December meetings of the Board of Directors. In general, the Company expects to
declare a quarterly dividend per share of Capital Stock which would result in
the distribution of most or all of the taxable income earned in that quarter.
See "Risk Factors -- Risks Associated with a New Enterprise -- Limited Operating
History of the Company; Net Losses; Failure to Achieve Projected Levels of
Mortgage Loan Originations" and "Dividend Policy and Distributions."
RESULTS OF OPERATIONS
For the year ended December 31, 1997, the net loss of the Company was
$(1,774,311) as compared to $(1,305,866) for the period from February 7, 1996
(date of inception) to December 31, 1996. For the year ended December 31, 1997,
revenues were $10,032,591 as compared to $1,160,435 for the period from February
7, 1996 (date of inception) to December 31, 1996. For the year ended December
31, 1997, net gain-on-sale of mortgage loans was $5,967,647 as compared to
$446,771 for the period from February 7, 1996 (date of inception) to December
31, 1996. For the year ended December 31, 1997, interest income was $3,756,870
as compared to $621,601 for the period from February 7, 1996 (date of inception)
to December 31, 1996. Revenues, net gain-on-sale of mortgage loans and interest
income all increased as a result of increased Mortgage Loan production with an
emphasis on higher profit margin Subprime Mortgage Loans as compared to Prime
Mortgage Loans.
For the year ended December 31, 1997, salaries and employee benefits
expenses were $4,474,357 as compared to $390,018 for the period from February 7,
1996 (date of inception) to December 31, 1996. For the year ended December 31,
1997, general operating expenses were $4,313,236 as compared to $1,285,156 for
the period from February 7, 1996 (date of inception) to December 31, 1996.
Salaries and benefits and general operating expenses increased as a result of
opening branches outside the Mountain West region and the accompanying corporate
support staff.
For the year ended December 31, 1997, interest expense was $2,965,685 as
compared to $731,519 for the period from February 7, 1996 (date of inception) to
December 31, 1996. Interest expense increased as a result of increased warehouse
lines of credit and working capital borrowings required as a result of increased
Mortgage Loan production.
As of December 31, 1997, mortgage loans held for sale were valued at
$54,451,067 as compared to $24,147,713 as of December 31, 1996. Mortgage loans
held for sale increased as a result of increased production.
LIQUIDITY AND CAPITAL RESOURCES
Prior to July 31, 1997, the Company's principal need for capital resulted
from the expansion of its wholesale and retail branches and the need to fund
originations of Mortgage Loans. Such capital requirement was provided by
contributions of the Founders and the sale of preferred stock and subordinated
debt to ContiFinancial Corporation. As of December 31, 1997, the Company had
borrowed approximately $31.7 million under its warehouse facility and $1.8
million under its working capital facility with ContiFinancial Corporation. As
of December 31, 1997, ContiFinancial Corporation had converted $2.0 million of
the working capital facility into preferred stock.
The Company has financed, and until the closing of this Offering the
Company will finance, the origination and acquisition of Mortgage Loans in its
mortgage lending operations through warehouse facilities and reverse repurchase
facilities from several banks and financial institutions. The Company currently
has committed warehouse facilities and reverse repurchase facilities of $160.0
million from three institutions. Such warehouse and reverse repurchase
facilities are currently at various interest rates ranging from London
Inter-Bank Offered Rate ("LIBOR") plus 1.1% to LIBOR plus 3.25%, depending on
the nature of the Mortgage Loans collateralizing the applicable borrowing.
37
<PAGE> 42
The Company is dependent upon the closing of this Offering for the capital
necessary to fund the acquisition of, and long-term investment in, its Mortgage
Asset portfolio. The Company will also require additional warehouse and reverse
repurchase facilities and will need to arrange CMO financing. Management
believes that such facilities are readily available from various counterparties
and intends to obtain commitments therefor prior to the closing of this
Offering. The Company may require additional capital offerings to continue
growth of the Mortgage Asset portfolio. Additional capital may not be available
on terms satisfactory to management or at all. If so, the Company would be
limited in achieving asset growth beyond this Offering.
INFLATION
The financial statements and notes thereto presented herein have been
prepared in accordance with GAAP, which require the measurements of financial
position and operating results in terms of historical dollars without
considering the changes in the relative purchasing power of money over time due
to inflation. The impact of inflation is reflected in the increased costs of the
Company's operations. Unlike industrial companies, nearly all of the assets and
liabilities of the Company's operations are monetary in nature. As a result,
interest rates have a greater impact on the Company's performance than do the
effects of general levels of inflation. Inflation affects the Company's
operations, however, primarily through its effect on interest rates, which
normally increase during periods of high inflation and decrease during periods
of low inflation. During periods of increasing interest rates, demand for
Mortgage Loans and a borrower's ability to qualify for mortgage financing in a
transaction may be adversely affected.
YEAR 2000 COMPLIANCE
The Company will rely upon a significant number of computer software
programs and operating systems in conducting its operations, including software
purchased from third-party vendors and internally developed programs. To the
extent that these software applications contain source code that is unable to
appropriately interpret the upcoming calendar year "2000," some level of
modification or even possible replacement of such source code or applications
will be necessary. The Company has received written confirmation from its
primary software vendors that their applications are Year 2000 compliant or will
be before December 31, 1998. The Company is creating or revising all internally
developed software to be Year 2000 compliant. Given the information known at
this time, it is currently not anticipated that these "Year 2000" costs will
have any material adverse impact on the Company's business, financial condition
or results of operations.
38
<PAGE> 43
BUSINESS
GENERAL
RealTrust Asset Corporation ("RealTrust" or, with its subsidiaries, the
"Company") is a specialty finance company engaged in the business of
originating, purchasing, selling and servicing mortgage loans secured primarily
by first mortgages on single-family residences ("Mortgage Loans") and to a
lesser extent second lien Mortgage Loans ("Second Lien Mortgage Loans"). The
Company originates Mortgage Loans through 12 wholesale and 2 retail branch
offices. In addition, the Company has built a correspondent lending operation
that began purchasing Subprime Mortgage Loans (as defined below) in the fourth
quarter of 1997. The Company's mortgage operations originate and purchase fixed
and adjustable-rate Prime Mortgage Loans and Subprime Mortgage Loans (as defined
below). The Company intends to elect to be taxed as a real estate investment
trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"),
beginning with the tax year ending December 31, 1998 and build a portfolio of
primarily Subprime Mortgage Loans financed with structured debt instruments
while selling its Prime Mortgage Loans and a portion of its Subprime Mortgage
Loan production for cash gains. The portfolio is expected to generate net
interest income, which, upon election of REIT status, will not be taxed at the
corporate level. In addition, the sale of Prime Mortgage Loans and selected
Subprime Mortgage Loans originated or purchased by the Company will be conducted
through the Taxable Subsidiary and is expected to generate current income and
cash flow to fund in part the Company's mortgage lending operations. See
"Business -- Industry Developments." For the fiscal year ended December 31,
1997, the Company had originated or purchased $246.9 million of Subprime
Mortgage Loans, including $63.1 million of Subprime Mortgage Loans purchased
through its correspondent operations, and originated $260.5 million of Prime
Mortgage Loans. The Company is now and intends to remain self-advised and
self-managed.
The Company has five principal strategies: (i) to continue to increase
Mortgage Loan originations through high levels of service to independent brokers
and borrowers in its wholesale and retail channels, (ii) to expand correspondent
mortgage lending activities, (iii) to convert from selling all Mortgage Loan
production to building a portfolio of Mortgage Assets primarily comprised of
Subprime Mortgage Loans, (iv) to sell certain Mortgage Loans for cash gains, and
(v) to elect to be taxed as a REIT under the Code, beginning with the tax year
ending December 31, 1998.
To date, the Company has sold substantially all of its Subprime Mortgage
Loan production on a servicing-released basis, primarily to ContiFinancial
Corporation (with its affiliates ContiMortgage Corporation, ContiTrade Services,
L.L.C., ContiFinancial Services Corporation, "ContiFinancial Corporation").
Subsequent to this Offering, the Company will shift from selling all of its
production to building a portfolio of Mortgage Assets primarily comprised of
Subprime Mortgage Loans financed with structured debt. The Company intends to
use the net proceeds of this offering to provide the equity base for owning a
portfolio of Mortgage Assets and realizing the net interest income from such
portfolio.
The Company will elect to be taxed as a REIT under the Code, beginning with
its tax year ending December 31, 1998. Upon such election, the Company will
generally not be subject to federal income tax to the extent that it distributes
its earnings to its stockholders and maintains its qualification as a REIT.
Management believes that a REIT is the most desirable structure for owning
Mortgage Assets due to the elimination of corporate-level income taxation. In
addition, because the Company will not accept deposits like traditional lenders,
it will be subject to substantially less regulatory oversight and will incur
lower compliance expenses compared to banks, thrifts and other originators or
holders of Mortgage Assets.
The Company's principal business objectives are to increase earnings per
share and cash available for distribution to stockholders and to enhance
stockholder value. The Company intends to accomplish these goals primarily by
capitalizing on the relatively high yields available from investing in Subprime
Mortgage Loans. The Company will derive income from two principal business
activities:
(i) Operation of the Company's mortgage lending business which will
generate income from its mortgage banking activities and will supply
Subprime Mortgage Loans for long-term investment through the proposed tax
advantaged REIT structure; and
39
<PAGE> 44
(ii) Management of the Mortgage Asset investment portfolio which,
similar to banks and savings institutions, will generate net interest
income based upon the difference between the interest earned on its
Mortgage Assets and the interest paid on its borrowings.
The Company's business structure benefits its stockholders because, as the
Company builds its investment portfolio, income will be more a function of the
size of the investment portfolio and interest differential between its Mortgage
Assets and borrowings than Mortgage Loan production volume. As a result, if the
market environment for Mortgage Loan originations becomes less attractive, the
Company's management believes it will have greater flexibility to reduce its
Mortgage Loan production while experiencing less volatility in quarterly
earnings relative to competitors who do not have investment portfolio earnings.
COMPETITIVE ADVANTAGES
Management believes that the Company will be able to compete effectively
against, and generate relatively attractive rates of return to stockholders
compared to, most of its competitors as a result of:
- Management that has previously built extensive mortgage banking
operations and managed large investment portfolios;
- A Mortgage Loan production franchise and investment portfolio focused on
relatively higher margin Subprime Mortgage Loans;
- Structured debt instruments to finance Mortgage Assets held in the
Company's investment portfolio instead of gain-on-sale securitizations;
- The tax advantages offered by electing REIT status for fiscal year 1998
and maintaining such status thereafter;
- A self-advised and self-managed corporate governance structure which
limits potential conflicts of interest;
- Exemption from state and federal regulations imposed on banks and
thrifts and the corresponding costs of insurance and oversight; and
- The ability to sell Mortgage Loans for cash gains (see
"Business -- Industry Developments.").
EXPERIENCED MANAGEMENT TEAM
The Company's two primary executive officers, John D. Fry and Terry L.
Mott, collectively have extensive experience in building and operating mortgage
banking operations in a variety of environments, including building Mortgage
Loan production and management teams, and creating and implementing policies,
budgets and controls. Mr. Fry, CMB, formed the Company in February, 1996 and has
been the President, Chief Executive Officer and Chairman of the Board since
inception. Mr. Mott has been the Executive Vice President of the Company
primarily responsible for Mortgage Loan production and a Director since
inception. Mr. Fry began his mortgage banking career in 1966. From 1984 to 1995,
Mr. Fry built the operational capacity of Goldome Realty Credit Corp., located
in Buffalo, New York, and ComUnity Lending, Inc., in San Jose, California, to
the multi-state, multi-billion dollar Mortgage Loan funding and servicing level.
Mr. Fry commenced ComUnity Lending's subprime mortgage lending operations which
produced $8.0 million per month at the time of his departure in 1994. Mr. Mott
began his career in mortgage banking in 1977. From 1980 to 1988, Mr. Mott was
the regional Vice President at Fleet Mortgage Corp. where he developed and
managed the retail and wholesale production for the western United States. From
1988 to 1994, Mr. Mott was Executive Vice President and served on the executive
committee for Medallion Mortgage Company where he was responsible for growing
the retail and wholesale Mortgage Loan production from $5.0 million per month to
over $300.0 million per month in a period of six years. Mr. Mott left AccuBanc
Mortgage, the successor to Medallion Mortgage Company, in December, 1995 to form
the Company with Mr. Fry.
40
<PAGE> 45
In contemplation of this Offering and the proposed business strategy of the
Company, the Company has hired additional executive management team members,
including John P. McMurray and Steven K. Passey. Mr. McMurray joined the Company
in February, 1998, as Executive Vice President of Secondary Marketing and Asset
Liability Management. Prior to joining the Company, Mr. McMurray was President
of Keystroke Financial, Inc., a start-up internet mortgage origination company.
From 1995 to 1996, Mr. McMurray was Executive Vice President and Director, Risk
Management and Capital Markets for Crestar Mortgage Corporation where he was
responsible for interest rate and credit risk management, as well as hedging and
loan sales activities. From 1982 to 1995, Mr. McMurray served in various
management positions with BancPlus Mortgage Corp., most recently serving as
Senior Vice President, Capital Markets. Mr. McMurray is a Chartered Financial
Analyst and a Certified Public Accountant. Mr. McMurray received a Master of
Science degree in real estate from Massachusetts Institute of Technology, a
Masters of Business Administration degree from the University of Texas, San
Antonio and a Bachelor of Science degree from Trinity University. Mr. Passey
joined the Company in October, 1997 as Senior Vice President and Chief Financial
Officer. Prior to joining the Company, Mr. Passey was in the financial services
area at KPMG Peat Marwick LLP for eight years, most recently as a manager
responsible for accounting and audit work for financial companies. Mr. Passey is
a Certified Public Accountant and received a Bachelor of Science degree in
accounting from the University of Utah.
HIGHER MARGIN SUBPRIME MORTGAGE LOANS
The Company believes that its strategy of continuing to shift its
production operations from the origination of Prime Mortgage Loans to the
origination and purchase of Subprime Mortgage Loans, and its intent to focus its
Mortgage Asset portfolio on Subprime Mortgage Loans will allow the Company to
generate higher earnings and dividends on a risk-adjusted basis than if the
Company originated and invested in Prime Mortgage Loans. Subprime borrowers
generally have substantial equity in the property securing the Mortgage Loan,
but have impaired or limited credit profiles or higher debt-to-income ratios
than traditional mortgage lenders allow. Subprime Mortgage Loan borrowers also
include individuals who, due to self-employment or other circumstances, have
difficulty verifying their income, and may be individuals who prefer the prompt
and personalized service provided by the Company. These types of borrowers are
generally willing to pay higher Mortgage Loan origination fees and interest
rates than those charged by conventional lending sources. One important
consideration in underwriting Subprime Mortgage Loans is the nature and value of
the collateral securing the Mortgage Loans. The Company believes that the amount
of equity required in the real estate securing the Mortgage Loans, together with
the fact that a substantial majority of the Mortgage Loans originated or
purchased by the Company are secured by borrowers' primary residences, reduces
the risks inherent in Subprime lending. Management believes that the potentially
higher yields and prudent underwriting standards required on the Company's
Subprime Mortgage Loans will combine to generate more attractive risk-adjusted
returns than can be earned through originating, purchasing and investing in
Prime Mortgage Loans. See "Risk Factors -- Risks Associated with the Mortgage
Lending Operation Competition in the Subprime Mortgage Lending Market; Changes
to Competitive Environment."
STRUCTURED DEBT INSTRUMENTS
The Company intends to finance adjustable-rate Subprime Mortgage Loans held
in its investment portfolio through structured debt instruments, where the
emphasis is on earning net interest income over time, which allows the Company
to take full advantage of its REIT status. The Company's mortgage investment
portfolio financed with structured debt instruments will allow it to produce a
tax-advantaged stream of income, and thus dividends to stockholders, due to the
profit in the Company's adjustable-rate Subprime Mortgage Loans being recognized
in the REIT structure as net interest income, rather than through fully taxable
gain-on-sale income if the Company were to sell such Mortgage Loans in REMIC
transactions. The accounting for gain-on-sale REMIC transactions presents as
current income the present value of expected future cash flows from the Mortgage
Loans sold. Actual income is subject to revision if actual losses, interest
rates and prepayment experience differ from the assumed levels.
41
<PAGE> 46
ADVANTAGES OF REIT TAX STATUS
As a REIT, the Company will generally pass through earnings to stockholders
without federal income tax at the corporate level. Thus, the Company expects
higher net earnings available to holders of Capital Stock than traditional
mortgage lending institutions which are subject to federal income tax.
CORPORATE GOVERNANCE WHICH LIMITS POTENTIAL CONFLICTS OF INTEREST
RealTrust and the Taxable Subsidiary will be a vertically integrated
organization, which is self-advised and self-managed. The Company is structured
to minimize the potential conflicts of interest between the mortgage lending
operation and the Mortgage Asset portfolio management operation. Such conflicts
can arise in REITs where the incentives and interest of management are dependent
on the size of the Mortgage Loan portfolio rather than return on equity or
stockholder returns. Such conflicts are common in entities which are externally
advised and which have management contracts or situations where management's
compensation is not directly related to the Company's performance or return to
stockholders. The Company's primary management incentive programs are dependent
on return on equity (the incentive bonus plan, of which half is paid in Common
Stock of the Company and half is paid in cash) and stock price appreciation
(stock option plans). See "Management -- Executive Compensation." The Company
will be subject to certain potential conflicts of interest since the voting
control of the Taxable Subsidiary is held by the Founders. See "Risk
Factors -- Risks Associated with the Company's Combined Operations and this
Offering -- Control by Management and Certain Affiliates; No Voting Control of
the Proposed Taxable Subsidiary; Potential Conflicts of Interest."
EXEMPTION FROM STATE AND FEDERAL REGULATION
Management believes that the proposed REIT structure provides a more
attractive vehicle for investing in Mortgage Loans than is provided by the
structure generally used by regulated financial institutions, because the
Company will not be subject to most of the federal and state regulations imposed
upon federally-insured financial institutions, and, therefore, will not incur
the related costs of deposit insurance and compliance. Furthermore, the Company
will not maintain the costly branch banking networks required by banks and
savings institutions to obtain deposit bases, their primary source of capital.
Although banks and savings institutions generally pay lower interest rates on
their deposit bases than the Company will pay for its borrowings, the costs of
federal deposit insurance and of operating and maintaining such branch networks
are substantial. The Company therefore believes that its operating costs will be
lower than regulated financial institutions of comparable asset size, and, as a
result, that the Company has the potential to earn higher net returns on its
Mortgage Loan portfolio.
LOAN SALES FOR CASH GAINS
The Company's wholesale, retail and correspondent channels originate and
purchase Prime and Subprime, fixed and adjustable-rate Mortgage Loans. The
Company plans to build its Mortgage Asset portfolio primarily by retaining
selected Subprime Mortgage Loans originated and purchased. The remaining
Mortgage Loans originated and purchased will be sold for cash gains to various
mortgage investors. See "Business -- Industry Developments." The Company expects
to sell all of the Prime Mortgage Loans and certain of the Subprime Mortgage
Loans and Second Lien Mortgage Loans originated through the wholesale and retail
channels. The Company intends to sell its entire economic interest in these
Mortgage Loans and does not intend to hold residual interests. The sale of these
Mortgage Loans is expected to generate substantial current income and cash flow
to fund, in part, the mortgage lending operations. Such sales are accomplished
through the Taxable Subsidiary.
OVERVIEW OF SUBPRIME MORTGAGE MARKET
According to Inside Mortgage Finance Publications, Inc., for the years 1995
through 1997, the residential Mortgage Loan market generated annual Mortgage
Loan volume in excess of $630.0 billion per year. The majority of these
originations (approximately 80% to 90%) were Prime Mortgage Loans. The remaining
42
<PAGE> 47
balance of 10% to 20% (approximately $85.0 to $150.0 billion) of the
originations were Subprime Mortgage Loans.
The Company believes that there is strong national demand by borrowers for
Subprime Mortgage Loans. Across the country, many borrowers have suffered
dislocation and temporary unemployment, resulting in negative entries on their
credit reports. Erratic market and economic conditions and other factors have
resulted in high ratios of debts to assets and high levels of credit card and
other installment debt for these individuals. In addition, more borrowers are
choosing to become self-employed. These are some of the circumstances which
create the market for Subprime Mortgage Loans.
One of the significant differences between the Prime Mortgage Loans and the
Subprime Mortgage Loan markets has been the comparative dependence upon the
overall level of interest rates. Generally, the Subprime Mortgage Loan market's
historical performance has been less sensitive to interest rate changes. This is
evident by the growth in Subprime Mortgage Loan originations from 1993 through
1995. While the Prime Mortgage Loan market experienced a decline in originations
of more than 40% during that period, due primarily to an increase in interest
rates, Mortgage Loan originations in the Subprime Mortgage Loan market continued
to grow at an annual rate of 10% to 15% over the same three-year period.
According to Inside Mortgage Finance Publications, Inc., the estimated size
of the Subprime Mortgage Loan originations in 1997 was approximately $124.5
billion. Historically, the Subprime Mortgage Loan market has been a highly
fragmented niche market dominated by local brokers with direct ties to investors
who owned and serviced this relatively higher margin, riskier product. Although
there have recently been several new entrants into the Subprime Mortgage Loan
business, the Company believes the Subprime Mortgage Loan market is still highly
fragmented, with no single competitor having more than a 5.6% market share by
volume for the year-ended December 31, 1997. The growth and profitability of the
Subprime Mortgage Loan market, the demise of numerous depository financial
institutions in the late 1980s which had served this market, and reduced profits
and Mortgage Loan volume at traditional financial institutions have together
drawn new participants and capital to the Subprime Mortgage Loan market.
Management believes the Subprime Mortgage Loan market requires more business
judgment from underwriters in evaluating borrowers with previous credit
problems. Subprime Mortgage Loan lending is also generally a lower volume/higher
profit margin business rather than the generally higher volume/lower profit
margin Prime Mortgage Loan business to which traditional mortgage bankers have
become accustomed. Subprime Mortgage Loan lending is also more capital intensive
than the Prime Mortgage Loan market due to the fact that the securitization
function requires a higher level of credit enhancement which must be provided by
the issuer in the form of over-collateralization or subordination.
The Company believes that the Subprime Mortgage Loan market will continue
to grow and to generate relatively attractive risk-adjusted returns over the
long term due in part to the following reasons: (i) growth in the number of
existing homeowners with negative entries on their credit reports; (ii) growth
in the number of immigrants with limited credit histories who are in the prime
home buying ages of 25 to 34; (iii) growth in the number of self-employed
individuals who have sources of income which are inconsistent and difficult to
document; (iv) growth in consumer debt levels which are causing many borrowers
to have higher debt/income ratios; and (v) growth in consumer bankruptcy filings
which cause borrowers to be classified as Subprime Mortgage Loan borrowers.
INDUSTRY DEVELOPMENTS
The President's tax proposals contained in the 1999 Budget Plan released by
the Treasury Department on February 2, 1998 (the "1999 Budget Plan") include
several provisions that could adversely affect REITs. The 1999 Budget Plan has
been submitted to the Ways and Means Committee of the U.S. House of
Representatives (the "Ways and Means Committee") for review, which held its
first hearing on February 25, 1998, but has not taken any action to date.
Several industry and trade organizations representing REITs and mortgage
bankers, including the National Association of Real Estate Investment Trusts and
The Mortgage Bankers Association have
43
<PAGE> 48
expressed their opposition to those provisions of the 1999 Budget Plan which
affect REITs. However, despite such opposition, the 1999 Budget Plan may be
adopted as proposed.
The 1999 Budget Plan proposes to prohibit a REIT from owning, by vote or
value, more than 10% of the capital stock of any corporation. Such proposal is
intended to prevent REITs from conducting through a taxable subsidiary any
business which would be prohibited by the REIT itself. If adopted, such proposal
would require the Company to change the nature of its ownership in the Taxable
Subsidiary and the manner in which it conducts its business.
If adopted, the 1999 Budget Plan would require that RealTrust either (i)
acquire all of the capital stock of the Taxable Subsidiary and convert it into a
Qualified REIT Subsidiary, or (ii) divest itself of the preferred stock of the
Taxable Subsidiary. To convert the Taxable Subsidiary into a Qualified REIT
Subsidiary would require that the Taxable Subsidiary comply with all of the
income and assets tests for a REIT. While the active origination of Mortgage
Loans in itself does not violate any of the income or assets tests for
maintaining REIT status, the Service could attempt to treat the income from
frequent sales of Mortgage Loans as subject to the 100% tax on income from
prohibited transactions. Rather than pay the prohibited transaction tax, the
Company would likely curtail production of Mortgage Loans it does not intend to
retain in its investment portfolio. See "Risk Factors -- Risks Associated with
the Company's Combined Operations and this Offering -- Potential Effects of 1999
Budget Plan."
MORTGAGE LENDING BUSINESS
The Company originated its first Mortgage Loans in April, 1996. Since its
inception, the Company's Mortgage Loan origination volume has increased
significantly. The following table describes the Company's Mortgage Loan
production volume by quarter since the third quarter of 1996:
QUARTERLY MORTGAGE LOAN PRODUCTION
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
WHOLESALE RETAIL CORRESPONDENT TOTAL
------------------ ------------------ ------------- ------------------
QUARTER ENDED PRIME SUBPRIME PRIME SUBPRIME SUBPRIME PRIME SUBPRIME
------------- ------- -------- ------- -------- -------- ------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
December 31, 1997............................... $46,008 $68,480 $34,628 $3,816 $63,132 $80,636 $135,428
September 30, 1997.............................. 41,313 59,226 32,614 5,502 0 73,927 64,728
June 30, 1997................................... 25,716 27,439 26,811 4,784 0 52,527 32,223
March 31, 1997.................................. 33,513 12,456 19,913 2,068 0 53,426 14,524
December 31, 1996............................... 43,277 14,687 22,055 1,918 0 65,332 16,605
September 30, 1996.............................. 46,806 5,500 14,374 941 0 61,180 6,441
</TABLE>
The Company has demonstrated its ability to successfully expand its
operations while implementing proper policies and controls. The Company's
accomplishments to date include:
- Operating a wholesale channel that originated $146.6 million of Prime
Mortgage Loans and $167.6 million of Subprime Mortgage Loans for the
year ended December 31, 1997 and currently consisting of 12 branch
offices in 11 states;
- Developing and staffing a correspondent channel which produced $63.1
million of Subprime Mortgage Loans for the fourth quarter of 1997;
- Operating a retail channel that originated $114.0 million of Prime
Mortgage Loans and $16.2 million of Subprime Mortgage Loans for the year
ended December 31, 1997 and currently consisting of two branch offices
in Salt Lake City, Utah and Las Vegas, Nevada;
- Becoming licensed to conduct mortgage lending in 27 states;
- Preparing policies and procedures for underwriting, selling and
brokering Mortgage Loans, quality control, and asset management;
- Obtaining $160.0 million in warehouse financing facilities;
44
<PAGE> 49
- Establishing Mortgage Loan sales relationships with Mortgage Loan
investors;
- Creating its information management system to monitor and analyze
operations and financial performance; and
- Establishing a servicing relationship as the Company builds its own
servicing infrastructure.
MARKETING AND PRODUCTION STRATEGY
GENERAL
The Company acquires or will acquire Mortgage Loans from four sources: (i)
its wholesale channel through which Mortgage Loans are acquired from a network
of independent wholesale brokers, (ii) its correspondent channel through which
closed Mortgage Loans are purchased from other lenders, (iii) its retail channel
through which direct originations are obtained from its retail branches, and
(iv) to a lesser extent, its bulk acquisitions of Mortgage Loans from other
mortgage banks and financial institutions.
WHOLESALE CHANNEL
The wholesale channel, which originates Mortgage Loans through independent
loan brokers, accounted for $114.5 million, or 53.0%, of the Company's Mortgage
Loan production during the fourth quarter of 1997. As of December 31, 1997, the
wholesale channel originated Mortgage Loans through 12 branch offices located in
Boca Raton, Denver, Green Bay, Honolulu, Kansas City, Las Vegas, Newport Beach,
Phoenix, Portland, Sacramento, Salt Lake City and Spokane.
Wholesale originations of Mortgage Loans involve a network of brokers that
will offer the Company's Mortgage Loan products. Such mortgage brokers are
generally unable or unwilling to acquire and hold Mortgage Loans. Typically,
either brokers do not have the capital necessary to obtain warehousing
facilities or they prefer or require the cash generated from Mortgage Loan sales
to sustain operations. The Company acquires Mortgage Loans in the wholesale
channel at a lower cost than acquisitions of Mortgage Loans either through bulk
purchases or purchases of securities in the secondary mortgage market. The
Company currently has in excess of 600 active wholesale lending relationships.
The Company believes that it has been successful in penetrating the broker
market by providing prompt, consistent service, which includes (i) response time
efficiencies in the Mortgage Loan purchase process as a result of decentralized
underwriting, (ii) direct and frequent contact through a trained sales force,
(iii) competitive pricing, and (iv) a variety of pricing programs and Mortgage
Loan products.
The Company believes that the most important factor in attracting and
retaining Mortgage Loan originations from independent brokers is an efficient
Mortgage Loan processing system. The Company staffs each wholesale branch with
an experienced underwriter. By locating underwriters in branch offices, the
Company avoids delays resulting from the need to ship the Mortgage Loan
applications to a central processing site, as is typical of the Company's
competitors. The Company can underwrite and approve wholesale Mortgage Loan
purchases within 24 hours after receipt of a completed file.
The Company trains its loan officers, account executives and branch
managers in its Mortgage Loan products and processes. Such personnel then
maintain regular contact with independent brokers through scheduled sales visits
and telephone calls. The Company believes that regular and frequent contact with
high volume producers results in greater broker loyalty and more consistent
production.
The Company has a pricing model that takes into account changing market
conditions and is designed to allow the Company to purchase Mortgage Loans at
competitive prices that maintain adequate profit margins. After its election of
REIT status, the Company anticipates that it will offer more competitive pricing
relative to tax paying competitors as a result of the elimination of Federal
income tax at the REIT-level.
45
<PAGE> 50
The following table sets forth selected information relating to the
Company's wholesale Mortgage Loan originations during the periods shown:
<TABLE>
<CAPTION>
FOR THE QUARTER ENDED
---------------------
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30,
1997 1997 1997 1997 1996 1996
------------ ------------- -------- --------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
SUBPRIME:
Principal balance (in
thousands)................ $68,480 $59,226 $27,439 $12,456 $14,687 $ 5,500
Average principal balance
per Mortgage Loan (in
thousands)................ $ 104 $ 111 $ 100 $ 100 $ 96 $ 98
Principal Balance:
Fixed-rate (in
thousands)............. $18,079 $23,421 $10,677 $ 6,124 $ 8,162 $ 2,124
ARMs (in thousands)....... $50,401 $35,805 $16,762 $ 6,332 $ 6,525 $ 3,376
Combined weighted average
initial loan-to-value
ratio..................... 80.41% 79.24% 77.26% 79.13% 78.19% 79.03%
Percent of First Lien
Mortgage Loans............ 99.11% 97.65% 97.24% 92.95% 94.04% 96.31%
Percent of Mortgage Loans
with prepay protection.... 93.07% 91.37% 79.24% 46.16% 37.18% 37.98%
Property securing Mortgage
Loans:
Owner occupied............ 95.34% 96.55% 91.04% 99.36% 93.17% 97.51%
Non-owner occupied........ 4.66% 3.45% 8.96% 0.64% 6.83% 2.49%
PRIME:
Principal Balance (in
thousands)................ $46,008 $41,313 $25,716 $33,513 $43,277 $46,806
</TABLE>
The Company initially intends to increase wholesale Mortgage Loan
production through expanded marketing efforts by existing branches. Such
marketing efforts are intended to obtain greater percentages of production by
independent brokers who already sell to the Company. The Company intends to
continue to increase the percentage of Subprime Mortgage Loans originated
through its wholesale channel. The Company also intends to identify new areas of
the United States within which to establish wholesale branches, if such areas
are generating significant Subprime Mortgage Loan production.
CORRESPONDENT LENDING
In addition to the wholesale and retail operations, the Company has formed
a correspondent lending division which is specifically directed at the
acquisition of Subprime Mortgage Loans. The correspondent lending division
acquires closed Subprime Mortgage Loans through a national network of approved
Mortgage Loan originators ("Correspondents") that fund and close each Subprime
Mortgage Loan using their own funds then sell the Mortgage Loans to the Company.
Correspondent Lending Objective. The goal of the correspondent lending
division is to expand Subprime Mortgage Loan production while maintaining the
comprehensive quality control approach employed by the wholesale and retail
divisions of the Company. Correspondents will originate Subprime Mortgage Loans
to underwriting guidelines prepared or approved by the credit risk personnel of
the Company. In addition, the correspondent lending division provides approved
Correspondents with the Company's operational guidelines to control pricing,
delivery and funding of Subprime Mortgage Loans into the program.
The correspondent lending division will purchase Subprime Mortgage Loans
from mortgage bankers, commercial bankers and savings institutions on a
servicing released basis. Each Correspondent will maintain certain eligibility
criteria such as net worth requirements, an unqualified auditor opinion from a
nationally recognized or Company-approved accounting firm, mortgage origination
experience, quality control procedures and warehouse line capability, among
other requirements. Also, Correspondents make certain represen-
46
<PAGE> 51
tations and warranties with respect to, among other things, the Subprime
Mortgage Loans, the financial condition of the borrowers, the adequacy of
disclosure, first payment default and premium recapture.
Sales and delivery of Subprime Mortgage Loans to the correspondent lending
division will be conducted in two ways: (i) on a best efforts, loan-by-loan flow
basis and (ii) bulk purchases. For flow delivery, daily pricing is provided by
the secondary marketing department of the Company and the Correspondent may lock
in Mortgage Loan purchase prices through the toll free commitment desk. Subprime
Mortgage Loans identified for purchase by the Company are either (i)
re-underwritten by the Company or by independent contractors engaged by the
Company or (ii) subject to a post-purchase quality control audit to assure
guideline and documentation conformity. This flow method of acquisition is a
major target for the Company primarily because of the lower cost of acquisition.
Alternatively, the Company will acquire Subprime Mortgage Loans from these and
other Correspondents in bulk purchases that range from $1.0 million to $50.0
million in principal amount. Depending on Mortgage Loan and pool
characteristics, such as weighted average coupon ("WAC"), weighted average
loan-to-value ("WLTV"), weighted average maturity ("WAM"), prepayment penalties
and pool size, the premiums paid for bulk purchase can range between 50 to 200
basis points above those paid on a flow basis. Despite the higher cost, bulk
acquisitions enable economies-of-scale and may provide the Company with market
arbitrage opportunities.
Initial Correspondent Platform. In October, 1997, the Company entered into
a letter agreement with Nomura Asset Capital Corporation ("Nomura") to acquire
from Nomura Subprime Mortgage Loans and certain non-binding Correspondent
relationships between Nomura and several Correspondents through which Nomura has
actively purchased Subprime Mortgage Loans since 1994. Through October, 1997,
Nomura has purchased over $1.75 billion of Subprime Mortgage Loans through its
Subprime Mortgage Loan conduit operations.
In addition to purchasing Subprime Mortgage Loans directly from Nomura,
Nomura agreed to introduce the Company to certain of the Correspondents
currently selling Subprime Mortgage Loans to Nomura. Such relationships are not
contractually binding on the Correspondents, who remain free to sell to others.
However, the Company has commenced purchasing Subprime Mortgage Loans from many
of such Correspondents. The Company acquired $63.1 million of Subprime Mortgage
Loans through such Correspondents during the fourth quarter of 1997 (including
Nomura).
To the extent that the Company purchases more than $90.0 million of
Subprime Mortgage Loans from such correspondents before June 30, 1998, the
Company has agreed to pay Nomura a fee equal to 25 basis points of the principal
amount. Nomura also agreed to provide a $100.0 million reverse repurchase
facility for a period of one year. The Company has also agreed to allow Nomura
to participate as co-underwriter in any public offering of securities backed by
fixed-rate Subprime Mortgage Loans financed through such facility during the
term of the financing facility.
The Company views the assumption of the Nomura Correspondent relationships
and subsequent pipeline as a platform to build and develop the correspondent
production necessary to implement the Company's Mortgage Asset portfolio
strategy. The Company intends to expand the correspondent lending operation by
developing relationships with additional correspondents who can accumulate and
sell pools of Mortgage Loans in sizes ranging from $500,000 to $5.0 million. The
Company believes that such relationships can provide attractive Subprime
Mortgage Loans at prices that meet the Company's business plan objectives.
However, given the capital intensive nature of correspondent lending, the
Company does not expect to fully utilize its correspondent lending operations
until after the closing of this Offering.
47
<PAGE> 52
The following table sets forth selected information relating to the
Company's correspondent Mortgage Loan originations during the period shown:
<TABLE>
<CAPTION>
FOR THE QUARTER ENDED
DECEMBER 31,
1997
----------------------
<S> <C>
SUBPRIME:
Principal balance (in thousands).................. $63,132
Average principal balance per Mortgage Loan (in
thousands)...................................... $ 114
Principal Balance:
Fixed-rate (in thousands)....................... $20,259
ARMs (in thousands)............................. $42,873
Combined weighted average initial LTV ratio....... 76.78%
Percent of First Lien Mortgage Loans.............. 96.30%
Percent of Mortgage Loans with prepay
protection...................................... 22.80%
Property securing Mortgage Loans:
Owner occupied.................................. 96.04%
Non-owner occupied.............................. 3.96%
PRIME:
Principal balance (in thousands).................. $ 0
</TABLE>
The Company is preparing to manage the increased Subprime Mortgage Loan
volume that is anticipated to be generated by the correspondent lending division
upon the closing of this Offering. The Company has entered into contractual
relationships with industry recognized vendors who will provide operational
services to support the additional Mortgage Loan production. Advanta will
provide the servicing of all correspondent production. Advanta specializes in
contract servicing of home equity Mortgage Loans, and is considered one of the
foremost servicers in the industry. The Company will contract with a third-party
due diligence underwriter and a bonded custodian for the review of legal
documentation.
RETAIL CHANNEL
The retail channel, which originates primarily Prime Mortgage Loans through
the direct solicitation of borrowers, accounted for $38.4 million, or 17.8%, of
the Company's Mortgage Loan production during the fourth quarter of 1997. As of
December 31, 1997, the retail channel originated Mortgage Loans through branch
offices located in Salt Lake City, Las Vegas and Phoenix. The retail channel
includes traditional marketing activities conducted by retail loan officers, who
seek to identify potential borrowers through referral sources and individual
sales efforts, as well as high-volume targeted direct mail and telephone
solicitation. By creating a direct relationship with the borrower, retail
lending generally creates a more sustainable Mortgage Loan origination franchise
and provides the Company with greater control over the lending process. For
Mortgage Loans originated in the retail channel, the Company also receives the
origination fees paid by the borrower which offset the higher costs of retail
lending and may contribute to increased profitability. In addition, the Company
believes it is able to maintain the highest quality control over Mortgage Loans
originated through its retail branches.
48
<PAGE> 53
The following table sets forth selected information relating to the
Company's retail Mortgage Loan originations during the periods shown:
<TABLE>
<CAPTION>
FOR THE QUARTER ENDED
----------------------------------------------------------------------------------
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30,
1997 1997 1997 1997 1996 1996
------------ ------------- -------- --------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
SUBPRIME:
Principal balance (in
thousands)................ $ 3,816 $ 5,502 $ 4,784 $ 2,068 $ 1,918 $ 941
Average principal balance
per Mortgage Loan (in
thousands)................ $ 89 $ 79 $ 71 $ 52 $ 68 $ 157
Principal Balance:
Fixed-rate (in
thousands)............. $ 1,496 $ 2,490 $ 2,134 $ 1,447 $ 1,232 $ 434
ARMs (in thousands)....... $ 2,320 $ 3,012 $ 2,650 $ 621 $ 686 $ 507
Combined weighted average
initial loan-to-value
ratio..................... 75.88% 74.44% 73.40% 73.17% 75.16% 73.75%
Percent of First Lien
Mortgage Loans............ 82.39% 79.02% 74.34% 62.66% 80.01% 89.58%
Percent of Mortgage Loans
with prepay protection.... 57.53% 64.09% 64.72% 30.05% 22.29% 10.12%
Property securing Mortgage
Loans:
Owner occupied............ 95.34% 89.42% 98.44% 100.00% 100.00% 100.00%
Non-owner occupied........ 4.78% 10.58% 1.56% 0.00% 0.00% 0.00%
PRIME:
Principal Balance (in
thousands)................ $34,628 $32,614 $26,811 $19,913 $22,055 $14,374
</TABLE>
The Company believes that targeted direct mail and telephone campaigns
offer opportunities to increase Subprime Mortgage Loan originations within the
Company's existing retail branch offices. The Company intends to staff each
retail office with a minimum of two Subprime Mortgage Loan officers who will
utilize direct mail and telephone solicitation methods to generate Subprime
Mortgage Loans. The Company intends to focus on growing production within its
existing retail branch offices utilizing such origination methods rather than
opening new retail branch offices in the immediate future.
BULK PURCHASES
The Company may initially acquire a portion of its Mortgage Asset portfolio
through bulk acquisitions due to the fact that this channel allows the Company
the opportunity to invest the net proceeds of this Offering more quickly than
the other channels. Bulk purchases of Mortgage Loan pools ranging from $1.0
million to $50.0 million may be acquired from large originators or from mortgage
conduits. Bulk acquisitions of Mortgage Loans will be conducted by the same
personnel that manage the correspondent channel. Although similar in process,
the bulk acquisition process differs from the correspondent channel in that
Correspondents have established regular selling relationships with the Company
and may even have Company underwriting personnel on the Correspondent's
premises. Bulk sellers have no such continuing relationship. This method of
acquiring Mortgage Loans provides the lowest profit margin to the Company.
During periods in which access to growth capital is limited, the Company will
tend to reduce its bulk purchases of Mortgage Loans in order to allow for
greater wholesale, retail and correspondent volume to be acquired.
MORTGAGE LOAN PRODUCTS
The Company offers a broad variety of Mortgage Loan products through its
wholesale, retail and correspondent channels. Such products include both
Subprime Mortgage Loans for long-term investment by
49
<PAGE> 54
the Company and Prime Mortgage Loans held for sale to investors. The Company's
Mortgage Loan products currently include:
- Six month LIBOR indexed ARMs;
- Two and three year LIBOR indexed ARMs;
- One, three, five and seven year CMT indexed ARMs;
- 15, 20 and 30 year fixed-rate First and Second Lien Mortgage Loans;
- 30 year amortizing balloon Mortgage Loans; and
- Jumbo fixed-rate and adjustable-rate Mortgage Loans.
PRICING OF MORTGAGE LOANS
The Company will set purchase prices for Mortgage Loans it acquires from
its mortgage lending operations based on prevailing market conditions. Different
prices will be established for the various types of Mortgage Loans, commitment
periods and types of commitments (mandatory or best efforts). The Company's
standard pricing is based on the anticipated price it will receive upon sale or
financing of the Mortgage Loans, the anticipated interest spread realized during
the accumulation period, the targeted profit margin and the anticipated
issuance, credit enhancement and ongoing administrative costs associated with
such sale or financing. Alternatively, such pricing may be based on the
anticipated cost of financing such Mortgage Loans to maturity plus the
anticipated associated costs. The Company anticipates the ability to acquire
Subprime Mortgage Loans at prices which allow for attractive returns on equity
to be earned due to the high level of service delivered to Mortgage Loan
brokers, borrowers and Correspondents.
Following the issuance of a specific pricing commitment, the Company will
be subject to the risk of interest rate fluctuations and will enter into hedging
transactions to diminish such risk. Hedging transactions may include mandatory
or optional forward sales of Mortgage Loans or Mortgage Securities, mandatory or
optional sales of futures and other financial futures transactions. The nature
and quantity of hedging transactions will be determined by the management of the
Company based on various factors, including market conditions and the expected
volume of Mortgage Loan purchases. See "-- Interest Rate Risk Management."
STATE LICENSES
The Company has applied for and is licensed to conduct mortgage banking
operations in 27 states (including certain states which do not have formal
licensing requirements or in which the Company is exempt from registration):
Arizona, California, Colorado, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa,
Kentucky, Minnesota, Missouri, Montana, Nebraska, Nevada, New Mexico, North
Carolina, Ohio, Oklahoma, Oregon, South Carolina, South Dakota (wholesale only),
Texas, Utah, Washington, Wisconsin and Wyoming. Registration is pending in
Illinois, Michigan, Tennessee and Virginia.
UNDERWRITING AND QUALITY CONTROL STRATEGIES
UNDERWRITING GUIDELINES
The Company has created a comprehensive underwriting manual for use by its
Correspondents as well as its internal staff. The underwriting standards have
been prepared in accordance with the financing requirements of the rating
agencies under the guidance of the Chief Credit Officer. The Company's quality
assurance guidelines provide for various tests of the Mortgage Loans to be
performed both before and after purchase.
The Company underwrites all Mortgage Loans originated through its retail
and wholesale channels with a staff of in-house underwriters. The Company staffs
each office with a senior underwriter with a minimum of five years experience.
In larger offices, the Company may hire junior underwriters with more limited
experience to work directly with the senior underwriters. Upon being hired by
the Company, the underwriter undergoes an intensive three day training of the
Company's underwriting policies and procedures at the
50
<PAGE> 55
Company's headquarters in Salt Lake City. After the underwriter is trained to
the satisfaction of the Chief Credit Officer, he or she is then placed at a
retail or wholesale office. New underwriters are subject to a 30-day probation,
during which their work is more closely scrutinized by the Company.
The Company may delegate underwriting authority to Mortgage Loan
Correspondents who meet certain financial and performance criteria. Under the
delegated underwriting program, Mortgage Loans will be underwritten in
accordance with the Company's guidelines by the Correspondent and will be
purchased on the basis of the Correspondent's financial strength, historical
Mortgage Loan quality and other qualifications. Generally, under this program, a
Mortgage Loan Correspondent must have a minimum net worth of $400,000, an
unqualified auditor's opinion from a nationally recognized or Company-approved
accounting firm, quality control procedures, warehouse line capability and a
history of selling Mortgage Loans for a period of two years, among other
criteria. A sample of such Mortgage Loans will be initially reviewed by the
Company in accordance with its quality control manual in order for the
Correspondent to be granted delegated underwriting authority. The Company's
delegated underwriting program will enable Correspondents to deliver closed
Mortgage Loans to the Company in conformity with the Company's established
guidelines, relying on the Correspondent's representatives and warranties. To
date, no such delegated underwriting authority has been granted and all Mortgage
Loans purchased by the Company have been fully underwritten by the Company prior
to purchase. In order to better serve these customers, the Company has developed
a training program to train the Correspondents' underwriting staff in the basic
principles of Subprime Mortgage Loan credit decision-making. In addition to the
delegated underwriting program, smaller volume originators may submit Mortgage
Loans to the Company to be underwritten in accordance with the Company's
guidelines and by the Company's underwriting staff. In order to provide better
service to these customers, the Company will offer the option of providing an
underwriter to review files in the Correspondent's office. Under both methods,
Mortgage Loans are purchased by the Company only after completion of legal
documentation and eligibility criteria review. The following is a general
guideline of the eligibility criteria expected to be adopted by the Company
after this Offering.
51
<PAGE> 56
UNDERWRITING GUIDELINES (1)
FIRST LIEN MORTGAGE LOANS
<TABLE>
<CAPTION>
A+ RISK (2) A RISK A- RISK B RISK C RISK C- RISK
--------------- --------------- --------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Existing mortgage No 30-day late Maximum one Maximum three Maximum four Unlimited Unlimited 30-
history............ payments or 60- 30-day late 30-day late 30-day late number of 30- and 60-day late
day late payment and no payments and no payments and and 60-day late payments and a
payments within 60-day late 60-day late one 60-day late payments and maximum of two
last 12 months; payments within payments within payment within maximum of two 90-day late
one 30-day late last 12 months; last 12 months; last 12 months; 90-day late payments and
payment in last must be current not required to not required to payments within one 120-day
24 months; must at application be current at be current at last 12 months late payment if
be current at time. application application if LTV is 70% LTV is more
application time. time. or less; than 65%; if
time. maximum two LTV is 65% or
60-day late less, there may
payments or one be a current
90-day late notice of
payment if LTV default; not
is over 70%; required to be
not required to current at
be current at application
application time.
time.
Other credit......... No open No open Minor Prior defaults Significant Significant
collections collection derogatory acceptable; not prior defaults defaults
accounts or accounts or items allowed; more than acceptable; acceptable;
charge-offs charge-offs. not more than $1,500 in open generally, not open
within last 12 Generally must $500 in open collection more than charge-offs or
months. be paid through collection accounts or $2,500 in open collection
funding not accounts or charge-offs collection amounts may
exceeding $300. charge-offs open after accounts or remain open
open after funding. charge-offs after funding.
funding. open after
funding.
Bankruptcy filings... Generally, no Chapter 7 must Chapter 7 must Generally, no Generally, no Bankruptcy,
bankruptcy or have been have been bankruptcy or bankruptcy or notice of sale
notice of discharged at discharged at notice of notice of filings, notice
default filings least 2 years least of 2 default filings default filings of default
in last 3 prior; Chapter years prior; in last 2 in last 18 filing or
years. 13 must have Chapter 13 must years. Chapter months. One foreclosure
been discharged have been 13 allowed at year seasoning permitted on a
at least 1 year discharged at least one year for Chapter 13 case by case
prior. least 1 year prior with with basis.
prior. reestablished reestablished Generally, one
credit. credit. year seasoning
for Chapter 7
and NODs. No
seasoning for
Chapter 13 paid
at funding.
Debt service to 42-45% 45-50% 55% or less 60% or less 60% or less 65% or less
income ratio.......
Maximum loan-
to-value ratio: (3)
Owner occupied: 90-95% 85-90% 90% 70-85% 70-80% 70%
single family......
Owner occupied: 90% 80-90% 80-90% 75-85% 60-80% 65-70%
condo/two-to-four
unit...............
Non-owner 80% 75-80% 70-80% 65-75% 65-70% 60-65%
occupied...........
</TABLE>
- ---------------
(1) The letter grades applied to each risk classification reflect the Company's
internal standards and do not necessarily correspond to the classifications
used by other mortgage lenders. "LTV" means loan-to-value ratio. With
respect to A through C credit grades, the combined LTV of all Mortgage Loans
secured by any property is permitted to be up to 100%, with the first lien
Mortgage Loan at the percentages indicated.
(2) On A+ product Purchaser Mortgage Insurance ("PMI") is obtained on LTV's
above 90% with 30% coverage; and 25% coverage from 85.01 to 90%; no PMI is
required for 85% LTV or less.
(3) The maximum LTV set forth in the table is for borrowers providing full
documentation. The LTV is reduced five percent for limited documentation and
10% for stated income applications, if applicable.
52
<PAGE> 57
SECOND LIEN MORTGAGE LOANS
<TABLE>
<CAPTION>
A+ RISK A RISK A- RISK B RISK C RISK C- RISK
--------------- --------------- --------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Existing mortgage No 30-day late Maximum one Maximum two Maximum three Maximum four Must be paid
history (1)........ payments or 60- 30-day late 30-day late 30-day late 30-day or one from current
day late payment and no payments and no payments and no 60-day late loan proceeds.
payments within 60-day late 60-day late 60-day late payments within
last 12 months. payments within payments within payment within last 12 months;
last 12 months; last 12 months; last 12 months; must be current
must be current must be current must be current at closing.
at closing. at closing at closing.
Other credit......... Credit paid as Consumer should Consumer should May exhibit May exhibit Evaluated on a
agreed. be paid as be paid as some 30 and 60- some 60 and 90- discretionary
agreed in last agreed in last day day basis.
12 months. 12 months. delinquencies. delinquencies. Delinquent
credit brought
current at
closing.
Bankruptcy filings... No bankruptcies No bankruptcies No bankruptcies No bankruptcies No bankruptcies Acceptable with
in last 60 in last 48 in last 24 in last 12 reasonable
months. months. months with months with explanations.
reestablished reestablished
credit. credit.
Debt service to 45% 45-50% 50% 50% 55% 55%
income ratio.......
Maximum loan-
to-value ratio: (2)
Owner occupied: 100% 100% 95% 85% 80% 75%
single family....
</TABLE>
- ---------------
(1) Consecutive "rolling" 30-day delinquencies will count as one 30-day
delinquency (up to three)
(2) Reduce ratio by five percent for condominiums and PUDs; 10% for 2 to 4
family properties and rural properties; 15% for manufactured housing; and
20% for investment properties and second homes.
53
<PAGE> 58
The following table sets forth information concerning the Company's
principal balance of fixed-rate and adjustable-rate Mortgage Loan originations
by borrower risk classification for the periods shown:
MORTGAGE LOAN PRODUCTION BY BORROWER RISK CLASSIFICATION
<TABLE>
<CAPTION>
FOR THE FOR THE QUARTER ENDED FOR THE
YEAR ENDED ------------------------------------------------------------------ PERIOD ENDED
DECEMBER 31, DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, DECEMBER 31,
1997 1997 1997 1997 1997 1996 1996(1)
------------ ------------ ------------- -------- --------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C> <C>
PRIME:
Percent of total purchases
and origination........... 51.27% 37.32% 53.32% 61.98% 78.63% 79.73% 86.68%
Combined weighted average
initial loan-to-value
ratio..................... 79.28% 78.84% 78.53% 80.78% 79.53% 79.53% 79.34%
Weighted average interest
rate:
Fixed-rate................ 7.97% 7.80% 7.84% 8.27% 8.13% 8.18% 8.32%
ARMs...................... 6.64% 6.57% 6.70% 6.68% 6.74% 6.74% 6.94%
Margin-ARMs............... 2.78% 2.48% 2.76% 2.76% 2.75% 1.00% 1.00%
SUBPRIME:
A-Risk Grade:
Percent of total purchases
and origination........... 29.36% 40.57% 36.31% 28.96% 12.71% 13.01% 9.16%
Combined weighted average
initial loan-to-value
ratio..................... 80.12% 80.38% 80.25% 78.15% 82.24% 78.17% 78.40%
Weighted average interest
rate:
Fixed-rate................ 10.54% 10.40% 10.62% 10.73% 11.06% 11.00% 10.96%
ARMs...................... 9.90% 9.88% 10.05% 9.85% 9.62% 9.20% 9.29%
Margin-ARMs............... 6.25% 6.36% 5.69% 6.30% 5.90% 5.67% 5.52%
B Risk Grade:
Percent of total purchases
and origination........... 7.48% 10.30% 6.98% 4.67% 6.32% 5.36% 2.95%
Combined weighted average
initial loan-to-value
ratio..................... 75.30% 75.65% 75.20% 72.31% 75.14% 78.37% 78.19%
Weighted average interest
rate:
Fixed-rate................ 11.02% 10.90% 11.23% 11.05% 10.95% 11.24% 11.19%
ARMs...................... 10.41% 10.56% 10.34% 10.44% 9.87% 9.80% 9.74%
Margin-ARMs............... 6.67% 6.91% 5.94% 6.80% 6.48% 6.43% 6.32%
C Risk Grade:
Percent of total purchases
and origination........... 2.73% 4.40% 1.61% 2.48% 1.97% 0.58% 0.54%
Combined weighted average
initial loan-to-value
ratio..................... 71.20% 70.11% 69.41% 76.18% 72.18% 78.84% 77.31%
Weighted average interest
rate:
Fixed-rate................ 11.55% 11.41% 12.37% 12.60% 12.04% 12.67% 12.12%
ARMs...................... 11.14% 11.12% 11.23% 11.34% 10.29% 10.71% 10.52%
Margin-ARMs............... 6.94% 7.08% 6.72% 6.77% 6.37% 6.75% 6.66%
C- Risk Grade:
Percent of total purchases
and origination........... 0.57% 0.86% 0.28% 0.21% 0.43% 0.17% 0.08%
Combined weighted average
initial loan-to-value
ratio..................... 62.54% 61.37% 56.01% 60.72% 59.55% 61.62% 61.62%
Weighted average interest
rate:
Fixed-rate................ 13.16% 12.83% 13.78% 14.13% 14.53% 13.86% 13.86%
ARMs...................... 12.06% 12.83% 13.12% 12.75% 13.50% n/a n/a
Margin-ARMs............... 7.03% 7.16% 7.79% 7.88% 8.88% n/a n/a
Unclassified (2).............. 8.59% 6.56% 1.50% 1.70% 0.00% 1.15% 0.59%
</TABLE>
- ---------------
(1) For the period from February, 1996 (inception) to December 31, 1996.
(2) Includes certain Mortgage Loans which the Company sold to third-party
investors without determining the credit classification.
54
<PAGE> 59
GEOGRAPHIC DIVERSIFICATION
Close attention will be paid to geographic diversification in managing the
Company's credit risk. While there will initially be some geographic
concentration in Mortgage Loans originated though the correspondent acquisition
channel, over time the Company plans to diversify its credit risk by selecting
target markets through both the wholesale and correspondent channels. The
Company believes that one of the best tools for managing credit risk is to
diversify the markets in which the Company originates and purchases Mortgage
Loans.
Currently, the Mortgage Loans originated by the Company are geographically
concentrated in Utah, Florida, Georgia and California. However, as newly
established retail and wholesale branches increase production, geographic
diversification will naturally occur. The following table sets forth aggregate
dollar amounts (in thousands) and the percentage of all Subprime Mortgage Loans
originated or purchased by the Company by state for the periods shown:
<TABLE>
<CAPTION>
FOR THE FOR THE QUARTER ENDED FOR THE
YEAR ENDED ------------------------------------------------------------------ YEAR ENDED
DECEMBER 31, DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, DECEMBER 31,
1997 1997 1997 1997 1997 1996 1996(1)
------------ ------------ ------------- -------- --------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Arizona....................... $ 5,634 $ 1,994 $ 1,521 $ 1,171 $ 948 $ 260 $ 260
Percent of total for
period.................... 2.28% 1.47% 2.35% 3.63% 6.53% 1.57% 1.13%
California.................... 27,970 11,940 10,663 4,782 585 0 0
Percent of total for
period.................... 11.33% 8.82% 16.47% 14.84% 4.03% 0.00% 0.00%
Colorado...................... 13,695 3,897 3,772 3,868 2,158 2,599 2,817
Percent of total for
period.................... 5.55% 2.88% 5.83% 12.00% 14.86% 15.65% 12.22%
Florida....................... 56,779 30,988 22,858 2,933 0 0 0
Percent of total for
period.................... 23.00% 22.88% 35.31% 9.10% 0.00% 0.00% 0.00%
Georgia....................... 28,794 28,158 636 0 0 0 0
Percent of total for
period.................... 11.66% 20.79% 0.98% 0.00% 0.00% 0.00% 0.00%
Hawaii........................ 4,239 1,549 1,944 746 0 0 0
Percent of total for
period.................... 1.72% 1.14% 3.00% 2.32% 0.00% 0.00% 0.00%
Idaho......................... 2,277 657 742 561 317 417 460
Percent of total for
period.................... 0.92% 0.49% 1.15% 1.74% 2.18% 2.51% 2.00%
Illinois...................... 5,750 5,750 0 0 0 0 0
Percent of total for
period.................... 2.33% 4.25% 0.00% 0.00% 0.00% 0.00% 0.00%
Kansas........................ 1,642 267 845 450 80 0 0
Percent of total for
period.................... 0.67% 0.20% 1.31% 1.40% 0.55% 0.00% 0.00%
Massachusetts................. 2,213 2,213 0 0 0 0 0
Percent of total for
period.................... 0.90% 1.63% 0.00% 0.00% 0.00% 0.00% 0.00%
Montana....................... 1,003 195 185 478 145 279 279
Percent of total for
period.................... 0.41% 0.14% 0.29% 1.48% 1.00% 1.68% 1.21%
New York...................... 12,393 12,393 0 0 0 0 0
Percent of total for
period.................... 5.02% 9.15% 0.00% 0.00% 0.00% 0.00% 0.00
Nevada........................ 8,904 2,901 2,978 2,234 791 661 759
Percent of total for
period.................... 3.61% 2.14% 4.60% 6.93% 5.45% 3.98% 3.29%
Oregon........................ 7,041 2,707 2,681 1,295 358 80 80
Percent of total for
period.................... 2.85% 2.00% 4.14% 4.02% 2.46% 0.48% 0.35%
Utah.......................... 44,244 13,414 12,397 9,794 8,639 11,628 17,584
Percent of total for
period.................... 17.92% 9.91% 19.15% 30.39% 59.48% 70.03% 76.30%
Virginia...................... 2,159 2,159 0 0 0 0 0
Percent of total for
period.................... 0.87% 1.59% 0.00% 0.00% 0.00% 0.00% 0.00%
Washington.................... 5,946 2,281 1,324 2,033 308 629 709
Percent of total for
period.................... 2.41% 1.68% 2.05% 6.31% 2.12% 3.79% 3.08%
Wisconsin..................... 4,713 1,996 1,223 1,494 0 0 0
Percent of total for
period.................... 1.91% 1.47% 1.89% 4.64% 0.00% 0.00% 0.00%
Other States Combined......... 11,507 9,969 958 385 195 52 98
Percent of total for
period.................... 4.66% 7.36% 1.48% 1.19% 1.34% 0.31% 0.43%
Total................. $246,904 $135,429 $64,727 $32,224 $14,524 $16,605 $23,046
</TABLE>
COLLATERAL APPRAISAL
The Company's underwriting standards are also intended to assess the value
of the mortgaged property and to evaluate the adequacy of such property as
collateral for the Mortgage Loan. All of the Mortgage Loans originated by the
Company's wholesale and retail channels, and purchased by the Company through
55
<PAGE> 60
Correspondents will be appraised by qualified independent appraisers. Such
appraisers inspect and appraise the subject property and verify that such
property is in acceptable condition. Following each appraisal, the appraiser
prepares a report which includes a market value analysis based on recent sales
of comparable homes in the area, and when deemed appropriate, replacement cost
analysis based on the current cost of constructing a similar home. The Company
intends to use only Financial Institutions Reform, Recovery and Enforcement Act
of 1989 ("FIRREA") licensed appraisers as part of its approval process. All
appraisals are required to conform to the Uniform Standards of Professional
Appraisal Practice adopted by the Appraisal Standards Board of the Appraisal
Foundation and must be on forms acceptable to FNMA and FHLMC. It is anticipated
that substantially all Mortgage Loans purchased through Correspondents will be
subject to a second full appraisal or appraisal review prior to purchase by the
Company. The Company has a formal review process for all appraisers, verifies
licenses annually and conducts new appraisals under its Quality Control Program.
QUALITY CONTROL PROGRAM
The Company has an extensive, systemized quality control and audit plan
currently in place. Each month, the Company randomly selects 10% to 15% of all
Mortgage Loans, including 10% from each branch and product type (with at least
one per month from each) to review. Representations and information from each
Mortgage Loan are verified against a checklist of over 60 items. Among such
verifications are completeness of the Mortgage Loan documents, additional
scrutiny of the borrower's credit report, employment and salary re-verifications
(or tax return scrutiny if the borrower is self-employed), closer scrutiny of
the appraisal, general review of the legal and closing documents, verification
of the owner occupancy status (if applicable) and a re-evaluation of the
creditworthiness of the borrower. Each discrepancy is given a grade based on its
severity, from inadvertent, non-impairing errors to a guideline violation
requiring immediate action against the borrower and the broker. Additionally,
10% of all Mortgage Loans selected for review each month are further selected
for closer scrutiny, including a new appraisal and a new credit report ordered
from different agencies. To date, all quality control has been performed by the
Company itself; however, it may outsource some or all of these functions in the
future. The Company will not, however, outsource any pre-closing quality
control.
CORRESPONDENT ELIGIBILITY REQUIREMENTS
Closed Mortgage Loans purchased by the Company will be originated by
various mortgage bankers and other mortgage lenders. Correspondents are required
to meet certain performance requirements established by the Company before they
are eligible to participate in the Company's Correspondent program and must
submit to periodic reviews by the Company to ensure continued compliance with
these requirements. The Company's current criteria for Correspondent
participation generally include a tangible net worth of at least $400,000. In
addition, Correspondents are required to have comprehensive loan origination
quality control procedures and must be approved and in good standing with HUD,
among other criteria. Each Correspondent is expected to enter into a
comprehensive agreement that provides for recourse by the Company against the
Correspondent in the event of any material breach of a representation or
warranty made by the Correspondent with respect to Mortgage Loans sold to the
Company or any fraud or misrepresentation during the Mortgage Loan origination
process. There is no assurance that such requirements will be applicable in the
future.
FINANCING LOANS HELD FOR SALE AND INVESTMENT PRIOR TO STRUCTURED DEBT FINANCING
The Company will finance its Mortgage Loan originations and purchases
through interim financing facilities such as bank warehouse credit lines and
reverse repurchase agreements. The Company has committed warehouse lines and
reverse repurchase facilities in place totaling $160.0 million with Nomura
Finance Credit Corporation, Bank United and ContiFinancial Corporation. A
reverse repurchase agreement is a borrowing device evidenced by an agreement to
sell securities or other assets to a third-party and a simultaneous agreement to
repurchase them at a specified future date and price, with the price
differential constituting interest on the borrowing. The Company is currently in
negotiations with dealer firms for additional reverse repurchase facilities to
fund production prior to long-term financing.
The Company's Subprime Mortgage Loan lending operation will be a capital
intensive business. Depending on the type of Mortgage Loan product originated,
the production channel and the financing source,
56
<PAGE> 61
the amount of capital required as a percentage of the balance of Mortgage Loans
originated may range from two percent to eight percent. See "-- Capital and
Liquidity Management -- Capital Allocation Guidelines." For illustration
purposes only, a hypothetical monthly Mortgage Loan volume of $25.0 million
would equate to a capital requirement of $500,000 to $1.75 million per month,
respectively and a hypothetical monthly volume of $50.0 million would equate to
$1.0 to $3.5 million per month, respectively. Due to the capital intensive
nature of this business, the Company's Subprime Mortgage Loan lending will be
operated through the Taxable Subsidiary. Operating though the Taxable Subsidiary
would give the Company the flexibility to sell its Mortgage Loan production as
whole loans or in the form of pass-through securities in the event it
encountered restrictions in accessing the capital markets in order to fund its
Subprime Mortgage Loan lending operation. See "Business -- Industry
Developments" and "Risk Factors -- Risks Associated with the Company's Combined
Operations and the Offering -- Potential Effects of 1999 Budget Plan." The
Company intends to raise the required capital in order to implement its
preferred strategy of realizing the income from adjustable Subprime Mortgage
Loans through net interest income. The Company intends to sell certain Mortgage
Loans, which are expected to be Prime and fixed-rate Subprime Mortgage Loans.
LOAN SALES
The Company, through its Taxable Subsidiary, has historically followed a
strategy of selling for cash gains all of its Mortgage Loan originations and
purchases through Mortgage Loan sales in which the Company disposes of its
entire economic interest in the Mortgage Loans (including servicing rights) for
a cash price that represents a premium over the principal balance of the
Mortgage Loans sold. See "Business -- Industry Developments." For the fiscal
year ended December 31, 1997, the Company sold $477.1 million of Mortgage Loans
through whole Mortgage Loan sales transactions. The Company did not sell any
Mortgage Loans through securitization during this period; however, substantially
all of the Mortgage Loans sold during this period were ultimately securitized by
the purchasers thereof.
The Company plans to build its Mortgage Asset investment portfolio by
retaining Subprime Mortgage Loans originated and purchased by its mortgage
operations. Prime Mortgage Loans, certain Subprime Mortgage Loans and Second
Lien Mortgage Loans originated and purchased, will, however, be sold for cash
gains to various mortgage investors. The sale of these Mortgage Loans is
expected to generate current income and cash flow to fund in part the mortgage
lending operations.
The Company seeks to maximize its revenue on whole Mortgage Loan sales by
closely monitoring institutional purchasers' requirements and focusing on
originating or purchasing the types of Mortgage Loans that meet those
requirements and for which institutional purchasers tend to pay higher premiums.
Whole Mortgage Loan sales are made on a non-recourse basis pursuant to a
purchase agreement containing customary representations and warranties by the
Company regarding the underwriting criteria applied by the Company and the
origination process. The Company, therefore, may be required to repurchase or
substitute Mortgage Loans in the event of a breach of its representations and
warranties. In addition, the Company sometimes commits to repurchase or
substitute a Mortgage Loan if a payment default occurs within the first month
following the date the Mortgage Loan is funded, unless other arrangements are
made between the Company and the purchaser. The Company is also required in some
cases to repurchase or substitute a Mortgage Loan if the Mortgage Loan
documentation is alleged to contain fraudulent misrepresentations made by the
borrower.
INFORMATION MANAGEMENT SYSTEMS
The Company has established, and continues to enhance, information
gathering and reporting systems to monitor and analyze virtually every aspect of
the mortgage lending business. The Company employs a combination of commercially
available and internally developed software to process and track each Mortgage
Loan in the Company's system from application to closing and sale.
Management reviews Mortgage Loan production data on a daily basis. The
Company's systems provide management with detailed reports on all aspects of the
business, including Mortgage Loan processing, underwriting, funding, secondary
marketing and accounting. Such reports include Mortgage Loan production
57
<PAGE> 62
to date (i) by branch, (ii) by loan type, (iii) by geographic location of the
property, (iv) by pre-payment penalty, and (v) by LTV.
The Management Information Systems Department is structured into two teams:
Hardware/Software Support and Development. The Hardware/Software Support team
has built the client server network operating on a Windows NT platform. The
backbone of the Company information system is a wide area network ("WAN")
employing fiber optic lines and T-1 connectivity to each of its retail and
wholesale branch offices, with the exception of the Hawaii branch which connects
to the WAN via the internet. With the WAN operational, construction of the
Company intranet site is underway, utilizing the Company-reserved domain name:
cmgfunding.com. The intranet site permits video-teleconferencing between all
Company sites, enabling face-to-face Company meetings and on-going procedural
training, and will enable the Company's underwriting and other manual guidelines
to be available on-line, with instantaneous updates as management refines or
changes any provision.
The Development team has focused on building a Microsoft-standard network
of software solutions. The backbone of the Company's software network is SQL
Server Database. It supports the relational database for all of the Company's
departments and activities. The Company's accounting system, Accuity, built by
State of the Art Software, relies on the SQL database and allows management to
generate a vast number of reports such as (i) costs of origination or
acquisition of Mortgage Loans; (ii) pricing and timing of secondary sales by
investor, loan type and other factors; (iii) funding and usage of warehouse
lines; and (iv) monthly and year-to-date accounting statements. The integration
of the management information system is ongoing and will soon link all of the
Mortgage Loan production and processing through ODBC (open database
connectivity) to both treasury and secondary marketing functions, permitting
management to plan and better monitor Mortgage Loan fundings and subsequent
sales. The Company believes that the integration of its information and
accounting systems will offer efficiency and information advantages over those
of many of its competitors.
The Company's information technology providers have recognized that the
Company is dedicated to building and maintaining an integrated, leading edge
information environment and have selected the Company as a beta-site for several
advancements in its current software systems. Both Interlinq, the manufacturer
of MortgageWare (the Company's loan processing, underwriting and funding
software) and State of the Art have requested the Company's participation in an
advisory capacity for current and future development of their products. One
innovation which is currently in testing, Thin-Client technology, will enable
management to determine the status of any Mortgage Loan in any branch in
virtually real time.
The fundamental integration of the Company's information systems will
enable the asset-liability manager to monitor and report on all Mortgage Loans
by asset class, age and credit rating, to relate such positions to the Company's
hedge positions at any given time, permitting management to instantaneously
determine a net value of assets and hedges. Sophisticated analytics including
option-adjusted spreads, price sensitivity, time-basis change, residual cash
flow analysis, and Monte Carlo simulations will be performed on an independent
software model, utilizing the Company's asset and position data imported from
the Company's SQL database.
The Company maintains a secure computing environment. The file server farm
is located in a locked central room. All external data lines are monitored for
intrusive activity and internal access if granted by administrator security
clearance only. A routine onsite/offsite backup procedure is maintained to
enable rapid recovery in the event of a catastrophic event. Accounting records
are protected on a period-by-period basis, and are burned in on write-once,
read-only CD media which is stored in a protected off-site location.
MORTGAGE INVESTMENT PORTFOLIO
The Company will acquire and manage a portfolio of Mortgage Assets,
primarily composed of Subprime Mortgage Loans originated and acquired by the
Company and financed with structured debt instruments. As with a bank or savings
and loan association, the Company's portfolio is expected to generate net income
to the extent that the yield on its Mortgage Assets exceeds the overall cost of
its borrowings. The Company will attempt to construct a portfolio which will
provide a relatively consistent level of net interest income through a
58
<PAGE> 63
variety of interest rate environments. The Company will acquire and manage this
portfolio of Mortgage Assets to maximize net interest income within prescribed
risk constraints.
The Company's strategy will be to earn an attractive risk adjusted return
on equity while the Company is originating and purchasing Subprime whole
Mortgage Loans for investment in the Mortgage Loan portfolio. Management's
expectation is that the highest long-term risk adjusted return on equity will be
earned through investing its capital in the residual class of long-term
financings of Subprime whole Mortgage Loans originated through its Mortgage Loan
acquisition channels.
The Company will not acquire residuals and has not and generally will not
acquire first loss subordinated bonds rated below BBB, or Mortgage Securities
rated below B. The Company could indirectly retain the subordinate class from
Mortgage Loans securitized by the Taxable Subsidiary. The Company may acquire
interest-only or principal-only mortgage strips to assist in the hedging of
prepayment or other risks. In addition, as discussed above, the Company may
create a variety of different types of assets, including the types mentioned in
this paragraph, through the normal process of CMO financing of the Company's own
Mortgage Assets. In no event will the Company (exclusive of its Taxable
Subsidiaries) acquire or retain any REMIC residual interest that may give rise
to excess inclusion income as defined under Section 860E of the Code. Excess
inclusion income realized by the Taxable Subsidiary is not passed through to
stockholders of the Company. See "Federal Income Tax Considerations -- Taxation
of Tax-Exempt Entities."
The Company will review each Mortgage Asset to be acquired to assess its
expected return, credit and liquidity risk, financing costs, the quality of the
issuer and the expected prepayment rate. The Company has developed a financial
model to evaluate each potential Mortgage Asset's impact upon the Mortgage Loan
portfolio as a whole. The Company will regularly monitor its purchases of
Mortgage Assets and the income from such Mortgage Assets, including income from
its hedging strategies, so as to ensure at all times that it maintains
RealTrust's qualification as a REIT and RealTrust's exempt status under the
Investment Company Act of 1940, as amended (the "Investment Company Act"). The
Company has engaged qualified accountants and tax experts to assist it in
developing appropriate accounting systems and testing procedures, and to conduct
quarterly compliance reviews designed to assist RealTrust in assuring compliance
with the REIT provisions of the Code and to ensure RealTrust's exempt status
under the Investment Company Act. See "Federal Income Tax
Considerations -- Qualification as a REIT" and "Risk Factors -- Failure to
Remain Exempt from Investment Company Act Provisions."
TYPES OF MORTGAGE ASSETS
The Company expects to retain primarily Subprime Mortgage Loans, all of
which are secured by first or second mortgages or deeds of trust on
single-family (one-to-four-units) residences. A substantial portion of the
Subprime Mortgage Loans originated and purchased by the Company are expected to
meet the long-term investment requirements of the Company. Those Mortgage Loans
which the Company does not hold will be offered for sale to national private
mortgage conduit programs in the secondary mortgage market. See
"Business -- Industry Developments" and Risk Factors -- Potential Effects of
1999 Budget Plan."
Mortgage Loans. The Company may retain Prime Mortgage Loans, including FHA
Loans or VA Loans, which qualify for inclusion in a pool of Mortgage Loans
guaranteed by GNMA. Under current regulations, the maximum principal balance
allowed on conforming Mortgage Loans ranges from $227,150 ($321,900 for Mortgage
Loans secured by properties located in either Alaska or Hawaii) for one-unit to
$436,600 ($618,675 for Mortgage Loans secured by properties located in either
Alaska or Hawaii) for four-unit residential loans. The Company may also retain
Subprime Mortgage Loans. Subprime single-family Mortgage Loans are single family
Mortgage Loans that do not qualify in one or more respects for purchase by FNMA
or FHLMC. The Company expects that a majority of the Subprime Mortgage Loans it
purchases will be Subprime because generally they vary in certain other respects
from the requirements of such programs including the requirements relating to
creditworthiness of the borrowers or they have original principal balances which
exceed the requirements for FHLMC or FNMA programs. A substantial portion of the
Company's Subprime Mortgage Loans meet the requirements for sale to national
private mortgage conduit programs in the secondary mortgage market which focus
upon the Subprime Mortgage Loan lending market.
59
<PAGE> 64
The Company expects to hold primarily ARMs. The interest rate on an ARM is
typically tied to an index (such as LIBOR or the interest rate on United States
Treasury Bills), and is adjustable periodically at various intervals, typically
from one month to one year. Such Mortgage Loans are typically subject to
lifetime interest rate caps and periodic interest rate and/or payment caps. The
Company anticipates that the majority of the Mortgage Loans will have lifetime
interest rate caps of 6% over the initial Mortgage Loan interest rate, although
some Mortgage Loans may have lifetime interest rate caps of as high as seven
percent or as low as five percent over such initial rate. The Company expects
the Mortgage Loans to have periodic interest rate caps of either one percent
every six months or 2% per year. Lifetime and periodic interest rate caps are a
function of market and competitive factors and are therefore subject to change
from the levels anticipated herein.
The Company may obtain credit enhancements such as mortgage pool or special
hazard insurance for its Mortgage Loans, in addition to private mortgage
insurance when specified by its underwriting criteria. Accordingly, during the
time it holds Mortgage Loans, the Company will be subject to risks of borrower
defaults, fraud and bankruptcies and special hazard losses that are not covered
by standard hazard insurance (such as those occurring from earthquakes or
floods). In the event of a default on any Mortgage Loan held by the Company, the
Company will bear the risk of loss of principal to the extent of any deficiency
between (i) the net proceeds from liquidation of the mortgage collateral and any
related insurance or guarantee and (ii) the principal amount of the Mortgage
Loan.
Mortgage Securities. The Company plans to purchase Mortgage Securities in
the capital markets. These Mortgage Securities generally have a higher level of
liquidity than the Mortgage Loans to be acquired or originated and are expected
to provide a relatively stable flow of interest income with relatively low
levels of credit risk compared to such Mortgage Loans. The Mortgage Securities
to be acquired by the Company will be backed by a pool of ARMs. These Mortgage
Securities entitle the holder to receive a pass-through of principal and
interest payments on the underlying pool of Mortgage Loans and will be
guaranteed by the federal government sponsored agencies or issued by certain
private institutions. Mortgage Securities issued by private institutions are
usually, but not always, rated by one of the major rating services. The Company
may, from time to time, invest in Mortgage Securities that are not investment
grade.
RETAINED INTERESTS IN STRUCTURED DEBT INSTRUMENTS
The Company intends to hold for long-term investment Subprime Mortgage
Loans produced by its mortgage lending operation and to finance such loans with
long-term financings through the issuance of CMOs. Under this approach, for
accounting purposes, the Mortgage Loans collateralizing any CMO remain on the
balance sheet as assets and the debt obligations (i.e., CMOs) appear as
liabilities. The Company's retained interest under this approach is reflected by
the excess of the assets over the related liabilities on the balance sheet. The
resulting stream of expected "spread" income will be recognized over time
through the proposed tax-advantaged REIT structure. Other forms of financing may
also be employed from time to time under which a "sale" of interests in the
Mortgage Loans will be reflected and gain or loss reflected for accounting
purposes at the time of sale. Under this form, only the net retained interest in
the securitized Mortgage Loans will remain on the balance sheet. Such sales will
be made through one or more of the Taxable Subsidiaries. See "-- Interest Rate
Risk Management."
The Company expects that its retained interests in its long-term financing,
regardless of the form used, will be subordinated to the classes of securities
issued to investors in such securitizations with respect to losses of principal
and interest on the underlying Mortgage Loans. Accordingly, any such losses
incurred on the underlying Mortgage Loans will be applied first to reduce the
remaining amount of the Company's retained interest, until reduced to zero.
Thereafter, any further losses would be borne by the investors or the insurers
in such securitizations rather than the Company.
The Company may also use financing as a tool to transfer some of the
interest rate risk of the Mortgage Loan collateral to the CMO bondholder and
credit risk to monoline bond insurers. Financing structures may include
floating-rate debt classes with life caps. The life cap structured in the bond
class pays down with the collateral, reducing the basis risk inherent in other
hedging strategies. The Company may pay a monoline bond
60
<PAGE> 65
insurer a monthly fee to assume a portion of the credit risk in a pool of
Mortgage Loans. The monoline insurer would also require the issuer to retain a
portion of the credit risk and over-collateralize a particular pool of Mortgage
Loans. The Company will structure its financing so as to avoid the attribution
of any excess inclusion income to the Company's stockholders. See "Federal
Income Tax Considerations -- Taxation of the Company's Stockholders."
Proceeds from such financing will be available to support new Mortgage Loan
originations. The Company's CMOs are expected to reduce the Company's interest
rate risk on assets held for long-term investment. CMOs are permanent financing
and are not subject to a margin call if a rapid increase in rates would reduce
the value of the underlying mortgages.
The Company plans to finance the retained interests in its CMOs through a
combination of equity and secured debt financings, including reverse repurchase
agreements.
Neither the Amended and Restated Articles of Incorporation nor the Bylaws
of the Company impose any limitations on the Company's ability to incur
borrowings, either secured or unsecured.
CAPITAL AND LIQUIDITY MANAGEMENT
CAPITAL ALLOCATION GUIDELINES
The Company's goal is to maintain a balance between the under-utilization
of leverage, which may diminish returns to stockholders, and over-utilization of
leverage, which could limit the Company's funding alternatives during adverse
market conditions. Therefore, the Company has adopted Capital Allocation
Guidelines ("CAG"). The Board will review actual usage of leverage on a
quarterly basis for purposes of ensuring that the Company is in compliance with
CAG. The CAG are intended to keep the Company properly leveraged by: (i)
matching the amount of leverage with the current perceived risk of the Company's
assets, and (ii) by retaining excess capital to provide for market conditions
that may substantially alter or increase the market's general assessment of
perceived risk for those Mortgage Assets.
The primary factors influencing the Company's liquidity under circumstances
of adverse market conditions are increases in interest rates and increases in
the general market perception of credit risk associated with residential
Mortgage Loans. Interest rate increases reduce the market value of the Company's
Mortgage Assets, and therefore reduce the quantity of financing that is
dependent on market values. Increased perceived credit risk tends to increase
the quantity of over-collateralization required by rating agencies to award
various investment grade ratings to the senior classes of structured financings
such as CMOs. Increased over-collateralization requirements reduce the quantity
of total financing prospectively available to the Company because the excess
collateral implied by the rate of over-collateralization required on the CMO
must be financed by the Company's equity rather than by the CMO.
To estimate the quantity of capital required for such adverse
circumstances, management has simulated capital requirements under adverse
conditions whereby interest rates increased instantaneously by 200 basis points
and foreclosure frequencies increased by over 77% above those currently
estimated as required to support a AAA rating on the senior class of CMOs issued
by the Company. To estimate the amount of capital required to support assets
financed by repurchase agreements, management used an option-adjusted pricing
framework and a sophisticated mortgage prepayment and pricing model. To estimate
the amount of potential over-collateralization for CMOs the Company employed a
generic rule that determines the amount of over-collateralization based on the
potential loss severity per Mortgage Loan and the rate of foreclosure frequency.
In general, over-collateralization equals potential loss severity times
foreclosure frequency. Applying this general rule to future CMOs, the 4.5% rate
of over-collateralization equates to a potential loss severity of 40% with a
foreclosure frequency of 11.25% (i.e., 40% X 11.25% = 4.5%). The CAG are to be
structured to allow for a substantial increase in the foreclosure frequency to
20% providing the capability to continue CMO issuance under circumstances of a
required eight percent over-collateralization (i.e., 40% X 20% = 8%).
61
<PAGE> 66
The following table depicts CAG requirements by asset/liability combination
under currently expected financing requirements and under adverse market
conditions.
CAPITAL ALLOCATION GUIDELINES
<TABLE>
<CAPTION>
(A) (B)
INCREMENT (C) = A+B
REQUIRED BY TOTAL
REQUIRED ADVERSE CAG
ASSET/LIABILITY COMBINATION EQUITY(1) MARKET(2) REQUIRED(3)
--------------------------- --------- ----------- -----------
<S> <C> <C> <C>
Subprime Mortgage Loans Financed by CMOs.................... 4.50% 3.50% 8.00%
Subprime Mortgage Loans Financed by Reverse Repurchase
Agreements................................................ 5.00% 3.78% 8.78%
Mortgage Securities Financed by Reverse Repurchase
Agreements................................................ 3.00% 4.99% 7.99%
</TABLE>
- ---------------
(1) Required equity is the expected amount of equity required by a typical
financing alternative for the types of assets held by the Company. There is
some variation in the equity requirements from time to time, and across the
spectrum of specific negotiated terms. From the lender or debt investor's
perspective the required equity represents an incremental value secured by
the financing agreement to which the lender or debt investor may immediately
recognize through collateral liquidation to cover liquidation costs on the
collateral should the debt obligor be unable to perform under terms of the
financing agreement.
(2) Increment Required by Adverse Market is the amount of excess capital
retained by the Company for each type of asset/liability combination in the
CAG for purposes of sustaining liquidity and funding alternatives during
adverse market conditions. The stressed conditions are a 200 basis point
increase in interest rates and an increase in foreclosure frequencies to
20%.
(3) Total CAG Required is the sum of the amount of equity required in various
forms of financing alternatives and the increment required to sustain these
resources under adverse conditions.
Implementation of CAG. The Company will implement the CAG under a
two-dimensional framework that considers the net market value of the Mortgage
Asset portfolio equity and the potential total over-collateralization in terms
of Mortgage Loan principal balance that may be required under adverse
conditions. By sustaining the net excess market value required by CAG, the
Company will possess the ongoing capacity to finance its Mortgage Assets. By
tracking requirements for structured financings the Company will maintain an
updated expectation for the required equity component of prospective
transactions.
Portfolio Financed with Reverse Repurchase Agreements. Each quarter the
Company marks to market its Mortgage Securities carried as available-for-sale.
This process is accomplished by obtaining market quotes from third parties,
including dealers that make markets in Mortgage Assets similar in nature to the
Company's and from mortgage banking concerns currently engaged in the business
of originating Mortgage Assets similar to those held by the Company. Market
values are then computed for the Company's assets using those market quotes
along with the Company's internally established assumptions related to
prepayments, losses, discount rates, and interest rate volatility. The market
value for all financing used by the Company net of the market value of hedges in
place as of the valuation date is then deducted from the current market value of
the Mortgage Assets. The remainder, which is the theoretical market value of
equity, is then compared to the weighted average amount required by CAG as of
the date of market valuation and actual required equity as established by the
financing agreements then in place. If the theoretical market value of equity is
less than required by CAG, management of the Company must prepare a plan for
presentation and approval by the Board of Directors to bring capital to the
required level.
Portfolio Financed with CMOs. Each quarter the Company will solicit updates
on the required over-collateralization from dealers and rating agencies for the
various types of Mortgage Assets the Company holds and produces. Should the
required equity increase substantially, the Company will evaluate at that time
the necessity for increasing the total capital allocation required for the
Company's net asset/liability position in light of the historical performance of
transactions in place to date and other financing vehicles then available to the
Company.
62
<PAGE> 67
SERVICING ACTIVITIES
Mortgage servicing represents the contractual right to receive a portion of
the interest payments (typically 25 to 50 basis points) of a Mortgage Loan in
exchange for the performance of certain services, including collection,
foreclosure, recordkeeping, disbursement of principal and interest to the
investor and payment of taxes and insurance. Mortgage Loan servicing also
includes the loss mitigation activities of contacting delinquent borrowers and
supervising foreclosures and property disposition in the event of unremediated
defaults. The Company will acquire Subprime Mortgage Loans with the servicing
rights retained.
During the period immediately following this Offering, Advanta will provide
subservicing for the Company while Management focuses on Mortgage Loan
production, Mortgage Loan processing, asset/ liability management,
administrative operations and securitization. This will allow the Company to
take advantage of the experience of Advanta's servicing staff, their computer
and customer service systems and collection procedure. The Company also intends
that Advanta will conduct all of the Company's servicing operations on Mortgage
Loans originated and for which the servicing rights are retained by the Company.
The Company currently services the Mortgage Loans in its warehouse prior to
sale. The Company intends to develop its own servicing capability in order to
oversee the performance of its Mortgage Loans more directly and to manage the
servicing relationship with its borrowers. The timing of this action will be
based on the completion of construction of the personnel and computer systems
necessary to properly manage a servicing department capable of servicing over
$1.0 billion in Subprime Mortgage Loans. While management expects that the
income from its servicing activities will exceed its cost of servicing, the
primary reason for servicing Mortgage Loans on which the Company has credit risk
exposure is as a loss mitigation strategy.
EARLY INTERVENTION, ASSET MANAGEMENT, AGGRESSIVE COLLECTION AND LOSS
MITIGATION TECHNIQUES
In both the servicing arrangements with Advanta and the Company's servicing
operations, the Company intends to emphasize the use of early intervention,
asset management, aggressive collection and loss mitigation techniques in its
servicing process to minimize losses on its whole loans and to preserve the
value of its residual interest in its CMO financings. The collections policy for
Subprime Mortgage Loans is designed (i) to curtail payment problems by
establishing early customer contact to communicate payment expectations and by
maintaining frequent customer contact to emphasize the priority of Mortgage Loan
repayment and (ii) to identify payment problems sufficiently early to permit the
Company to quickly address delinquency problems and, when necessary, to act to
preserve equity in a pre-foreclosure property.
With respect to Subprime Mortgage Loans, the Company will implement strict
servicing procedures. All mortgage payments are due on the first day of the
month. Late payment fees will accrue on the tenth day. The late payment fees on
Subprime Mortgage Loans will be the maximum allowable under applicable state
law. The subservicer will assign a counselor to each borrower immediately upon
closing of each Subprime Mortgage Loan who will alert the borrowers of the
Company's strict enforcement procedures and legal remedies available upon
nonpayment. The subservicer will generally mail payment coupons as a monthly
reminder to borrowers, enforce the 15-day late period and file notice of default
by the fifteenth day after the payment due date. See "-- Overview of Subprime
Mortgage Market."
ADVANTA SERVICING AGREEMENT
Under the Advanta Servicing Agreement, the Company is obligated to pay
Advanta a monthly servicing fee on the declining principal balance of each
Mortgage Loan serviced and a set-up fee for each Mortgage Loan delivered to
Advanta for servicing. Advanta is required to pay all expenses related to the
performance of its duties under the Advanta Servicing Agreement. Further,
Advanta is required to make advances of taxes and required insurance premiums
that are not collected from borrowers with respect to any Mortgage Loan, only if
it determines that such advances are recoverable from the borrower, insurance
proceeds or other sources with respect to such Mortgage Loan. If such advances
are made, Advanta generally will be reimbursed prior to the Company receiving
the remaining proceeds. Advanta also will be entitled to reimbursement by the
Company for expenses incurred by it in connection with the liquidation of
defaulted Mortgage Loans and in
63
<PAGE> 68
connection with the restoration of mortgaged property. If claims are not made or
paid under applicable insurance policies or if coverage thereunder has ceased,
the Company will suffer a loss to the extent that the proceeds from liquidation
of the mortgaged property, after reimbursement of Advanta's expenses in the
sale, are less than the principal balance of the related Mortgage Loan.
Under the Advanta Servicing Agreement, if the Company terminates such
agreement without cause or transfers the servicing of any amount of the Mortgage
Loans serviced by Advanta to another servicer, the Company must pay Advanta
certain penalties, fees and costs. Depending on the size of the Company's
Mortgage Loan portfolio serviced by Advanta, at any point in time, the
termination or transfer penalties that the Company will be obligated to pay
Advanta may be substantial. With respect to Mortgage Loans securitized by the
Company, the Company will not be able to terminate the servicer without the
approval of the trustee for such securitization.
Advanta is entitled to retain any late payment charge and assumption fees
collected in connection with the Mortgage Loans. Advanta receives any benefit
derived from interest earned on collected principal and interest payments
between the date of collection and the date of remittance to the Company and
from interest earned on tax and insurance impound funds. Under the Advanta
Servicing Agreement, Advanta is generally required to remit all principal and
interest scheduled to be collected from borrowers during the prior monthly
reporting period generally no later than the eighteenth day of each month. Upon
termination of the agreement with Advanta, the Company will pay a termination
fee equal to $100 per Mortgage Loan then serviced by Advanta.
INTEREST RATE RISK MANAGEMENT
The Company is subject to interest rate risk to the extent that the
interest rates on the Company's liabilities (reverse repurchase agreements and
CMOs) reprice more frequently, or on a different basis, than the interest rates
on the Company's Mortgage Assets. To mitigate this risk, the Company will follow
a strict interest rate risk management program managed by the Company's
Asset/Liability Manager, who had extensive experience in mortgage banking and
interest rate risk management for other financial institutions prior to his
employment with the Company. The Company's interest rate risk management program
will be formulated with the intent to mitigate the potential adverse effects
resulting from interest rate adjustment limitations on its Mortgage Assets and
the differences between the interest rate adjustment indices and interest rate
adjustment periods of its Mortgage Assets and related borrowings.
The Company's interest rate risk management program will encompass a number
of procedures. First, the Company will structure the liabilities of the Company
to have interest rate indices and adjustment periods that, on an aggregate
basis, correspond as closely as practicable to the interest rate adjustment
indices and interest rate adjustment periods of the Mortgage Assets. In
addition, the Company intends to structure its borrowing agreements to have a
range of different maturities (although substantially all will have maturities
of less than one year). As a result, the Company expects to be able to adjust
the average maturity of its borrowings on an ongoing basis by changing the mix
of maturities as borrowings come due and are renewed. In this way, the Company
will attempt to minimize any differences between interest rate adjustment
periods of Mortgage Assets and related borrowings.
The Company intends to use interest rate caps, interest rate swaps and
similar instruments to attempt to limit, fix or partially offset changes in
interest rates associated with its borrowings and changes in the value of its
Mortgage Assets. In a typical interest rate cap agreement, the cap purchaser
makes an initial lump sum cash payment to the cap seller in exchange for the
seller's promise to make cash payments to the purchaser on fixed dates during
the contract term if prevailing interest rates exceed the rate specified in the
contract. In this way, the Company intends generally to hedge as much of the
interest rate risk arising from lifetime rate caps on its Mortgage Assets and
from periodic rate and/or payment caps as the Company determines is in the best
interests of the stockholders of the Company, given the cost of such hedging
transactions and the need to maintain RealTrust's status as a REIT. See "Federal
Income Tax Considerations -- Qualification as a REIT -- Sources of Income." The
Company may also, to the extent consistent with its compliance with the REIT
provisions of the Code, buy and sell financial futures contracts, options and
trade forward contracts as a
64
<PAGE> 69
hedge against future interest rate changes; however, the Company will not
acquire such instruments unless the Company is exempt from the registration
requirements of the Commodities Exchange Act or otherwise complies with the
provisions of that Act.
The Company also considers its use of CMOs as a component of its interest
rate management strategy. CMOs address two of the problems caused by rapid
changes (primarily increases) in interest rates, margin calls and the potential
for negative interest spread on a Mortgage Loan. A rapid increase in interest
rates may cause the value of the Company's collateral used to secure reverse
repurchase agreements to decline, thereby forcing a "margin call" in which the
Company would be required to pledge additional collateral in order to support
the reverse repurchase agreement. When the Company is fully leveraged, all of
its assets may be encumbered as part of different financing arrangements, and
the only response to a margin call will be to sell Mortgage Assets. Selling
Mortgage Assets during periods of rapidly increasing interest rates may result
in the Company receiving a lower purchase price than may otherwise be received.
CMOs do not allow the investor the right to exercise a margin call, and in
periods of rapidly rising rates, the financing remains in place.
Another risk of rapidly rising interest rates is that the lifetime caps on
the Mortgage Loans are exceeded by the level of short-term rates (or the cost of
reverse repurchase agreements). To protect against this, the Company may imbed
an interest rate cap into the CMO structure which will approximately match the
interest rate cap on the underlying pool of Mortgage Assets. This structure is
not available to be imbedded within the Company's warehouse or reverse
repurchase agreements. While the purchase of a separate cap is available through
financial market intermediaries, the use of imbedding the cap in the CMO
structure may be preferred due to the fact that the Company is always evenly
matched within the Mortgage Assets of the CMO structure and, as Mortgage Assets
are paid down, the Company always retains a cap over the entire balance of the
Mortgage Assets.
The Company believes that it can implement a cost-effective interest rate
risk management program to provide a level of protection against interest rate
risks. However, an effective hedging strategy is complex, and no hedging
strategy can completely insulate the Company from interest rate risks. Moreover,
as noted above, certain of the federal income tax requirements limit the
Company's ability to fully hedge its interest rate risks. The Company intends to
monitor carefully, and may have to limit, its hedging strategies to assure that
it does not realize excessive hedging income or hold hedging Mortgage Assets
having excess value in relation to total Mortgage Assets, which would result in
the Company's disqualification as a REIT or, in the case of excess hedging
income, the payment of a penalty tax for failure to satisfy certain REIT income
tests under the Code, provided such failure was for reasonable cause. See
"Federal Income Tax Considerations -- Qualification as a REIT -- Sources of
Income." The Company may elect to conduct a portion of its interest rate risk
management operations through its Taxable Subsidiaries.
In addition, hedging involves transaction and other costs, and such costs
increase as the level of protection and period covered by the hedging
transaction increases. Hedging transaction costs also increase in periods of
rising or extremely volatile interest rates. Therefore, management does not
believe it will be cost effective to hedge all of its adjustable-rate
indebtedness and other interest rate risk. Further, certain losses on hedging
activities would be capital losses and would not be deductible to offset
ordinary income. In such a situation, the Company would have incurred an
economic loss of capital that would not be deductible to offset the ordinary
income from which dividends must be paid.
CREDIT RISK MANAGEMENT
To limit its risk both of default and of loss on the sale of foreclosed
property, the Company has instituted the following policies as part of its
overall credit policy. These policies are currently being followed in the
origination of Mortgage Loans.
Underwriting Policies. Initially, all Mortgage Loans submitted by
correspondents and brokers will be fully underwritten or re-underwritten by
the Company. Correspondents meeting appropriate net worth requirements may,
upon satisfactory re-underwriting of a minimum number of Mortgage Loan
files and completion of underwriting training provided by the Company, be
accorded delegated underwriting
65
<PAGE> 70
authority. All Mortgage Loans will be subject to a detailed review of the
underwriting decision prior to purchase.
LTV Limitations. The Company has determined maximum LTV ratios that
will be accepted depending upon the credit rating and other risk factors
assigned to the Mortgage Loans. (See "Business -- Underwriting and Quality
Control Strategies.") These LTV ratios are expected to provide significant
protection to the Company in the event of foreclosure, as well as provide
the borrower with a strong incentive to protect the Mortgage Loan from
being foreclosed.
Appraisal Review Requirements. The Company intends to generally
require a review appraisal for each Mortgage Loan prior to purchase. The
Company intends to use only FIRREA licensed appraisals and must be on forms
acceptable to FNMA and/or FHLMC as part of its approval process.
Additionally, appraisals for Mortgage Loans being considered at the 90% LTV
ratio and those Mortgage Loans randomly selected as part of quality control
will be desk reviewed. The Company intends to use only FIRREA licensed
appraisers as part of its approval process. All appraisals are required to
conform to the Uniform Standards of Professional Appraisal Practice adopted
by the Appraisal Standards Board of the Appraisal Foundation and must be on
forms acceptable to FNMA and FHLMC.
Repurchase Requirements. Mortgage Loans will be acquired through
correspondents who have entered into an agreement requiring repurchase of
Mortgage Loans found to breach any of a comprehensive list of
representations and warranties included in the correspondent agreement.
Such warranties include failure by the borrower to make the first payment,
fraud in any of the Mortgage Loan documents, and errors in the processing
or underwriting of the Mortgage Loan.
Selection and Approval of Correspondents. Correspondents are subject
to a thorough analysis, including checking of references and review of
financial statements, before submission to an executive committee for
approval. The Company will generally require its Correspondents to maintain
a minimum net worth of $400,000 in order to ensure their ability to meet
repurchase requirements.
Pre-purchase Quality Assurance Program. The Company will continue to
implement the thorough quality assurance procedures currently in use, which
generally include verifications of Mortgage Assets and employment and
obtaining an independent credit report prior to the purchase of the
Mortgage Loans. The post-purchase quality control is administered by one
full-time employee and one contract person focusing on quality control and
assurance, who are under the oversight of the Chief Executive Officer. The
Company intends to increase this staff as required by the level of
origination volume.
The Company will establish Mortgage Loan loss allowances on the balance
sheet in advance of anticipated losses. Such allowances are expected to be
sufficient to absorb losses from the sale of foreclosed properties, as well as
operating expenses related to delinquencies and foreclosures and carrying costs
of Mortgage Loans in default. Management believes that actual losses will not be
commensurate with the delinquency rates, however, due to two factors: (i)
Subprime Mortgage Loan borrowers tend to be late on payments from time to time
without going to foreclosure, thus inflating the delinquency rates, and (ii) the
lower LTV ratios tend to result in reduced losses on sale of foreclosed real
estate. Management believes its allowance for Mortgage Loan loss policies should
result in adequate coverage for losses while maintaining net yields.
MORTGAGE LOAN PREPAYMENTS
Mortgage Loans are generally paid in full prior to the maturity date of the
note which is typically 30 years from the date of the note. Prepayment rates are
affected by several factors, the most important of which are changes in
prevailing interest rates. Mortgage Loans will typically be prepaid more rapidly
in periods of declining interest rates as borrowers refinance to reduce monthly
payments. In periods of increasing interest rates, Mortgage Loan prepayment
rates will generally decline. Another factor which affects prepayment rates,
although to a less significant degree, is the level of home sales activity,
which generally increases when home prices are rising. Prepayment rates may also
be affected by changes in the borrower's credit rating or circumstances
following origination. Borrowers with improving credit may elect to prepay the
mortgages to
66
<PAGE> 71
take advantage of the lower rates associated with their higher credit grades,
even in periods of stable or rising interest rates. Conversely, borrowers with
deteriorating credit may be unable to take advantage of declining interest rates
as a result of their deteriorating credit.
Prepayments affect the Company in several ways. First, the amortization of
premiums or discounts related to the acquisition of the Mortgage Loans will be
affected by the speed of prepayment. Amortization of such premiums or discounts
is accounted for by the interest method by which the expense or income
recognition occurs on the basis of a fixed yield over the expected life of the
Mortgage Loan. The amortization of this premium or discount is included in the
interest income recognized each period. This method requires the use of
assumptions as to the timing of prepayments. Significant deviations in the
actual prepayment rate from the assumed rate may cause the Company to recognize
greater amortization expense for the period, and thereby reduce net interest
income. The Company's financial expectations assume a certain level of
prepayments. Actual prepayment speeds may accelerate to the point that the
return on equity earned from a given loan acquisition is less than expected, and
could even become negative. Second, prepayment of Mortgage Loans will require
that Mortgage Loans be acquired to replace those that have been prepaid. The
Mortgage Loans acquired may be at low introductory rates ("teaser rates") which
may negatively impact the Company's earnings until the rates on these Mortgage
Loans reprice to the full margin over the respective index ("fully indexed").
Third, hedging instruments may have been purchased to protect against interest
rate changes related to Mortgage Loans which may have prepaid more rapidly than
anticipated, resulting in excess coverage. Conversely, if the Mortgage Loans
prepay more slowly than anticipated, the Company may have less hedging coverage
than planned, and may have to acquire additional coverage. The Company's use of
the CMO financing structure may have these types of hedging instruments imbedded
within them, and be structured in order to better match the hedge and the
Mortgage Loans.
As an additional hedge against the risk of rapid prepayments, the Company
will offer ARM programs which carry a prepayment penalty. The borrower will be
required to pay a significantly higher starting interest rate and margin to
eliminate the prepayment penalty. Prepayment penalties are subject to market and
competitive factors and may, therefore, be subject to reduction or elimination.
State laws may also restrict the Company's ability to collect prepayment
penalties. As an additional protection against the negative financial impact of
loan prepayments, the Company intends to adopt policies and guidelines for its
servicing operations to be developed that will attempt to focus on borrowers
that have an incentive to refinance. The Company expects to implement a program
to recapture those Mortgage Loans by soliciting these borrowers directly rather
than losing them to another mortgage lender. The negative impact of the
amortization of the premium on these Mortgage Loans is expected to be somewhat
mitigated by the fact that the refinancing of these Mortgage Loans will be at a
price at or near par.
FUTURE CHANGES IN OPERATING, INVESTMENT AND ACCOUNTING POLICIES
The Board of Directors has established the investment, accounting and
operating policies and strategies set forth in this Prospectus. The Board of
Directors has the power to modify or waive such policies and strategies, such as
the mortgage investment policies, the leverage policies and the counterparty
credit policies, without the consent of stockholders, to the extent that the
Board Directors determine that such modification or waiver is in the best
interests of stockholders. However, if such modification or waiver relates to
the relationship of, or any transaction between, the Company and ContiFinancial
Corporation or any other Affiliated Person (as such term is defined in the
Glossary), the approval of a majority of the Independent Directors is also
required. Among other factors, development in the market which affect the
operating policies and strategies mentioned herein or which change the Company's
assessment of the market may cause the Board of Directors to revise the
Company's policies and strategies.
67
<PAGE> 72
[ORGANIZATIONAL CHART]
68
<PAGE> 73
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The directors and executive officers of the Company and their positions are
as follows:
<TABLE>
<CAPTION>
NAME POSITIONS CLASS OF DIRECTOR
---- --------- ------------------
<S> <C> <C>
John D. Fry, CMB Chairman of the Board and Chief Executive Officer III
Terry L. Mott Executive Vice President and Director II
John P. McMurray, Executive Vice President of Secondary Marketing
CFA, CPA and Asset Liability Management
Steven K. Passey, Senior Vice President and Chief Financial Officer
CPA
Carter E. Jones Independent Director II
Jeff K. Thredgold* Independent Director I
Daniel W. Campbell* Independent Director I
</TABLE>
- ---------------
* To be appointed upon closing of this Offering.
Information regarding the business background and experience of the
Company's directors and executive officers follows:
JOHN D. FRY, CMB, age 59, has been the President, Chief Executive Officer
and Chairman of the Board of the Company since inception in February, 1996.
During 1995, Mr. Fry commenced preparations for the organization of the Company.
From 1989 to 1994, Mr. Fry commenced the Subprime Mortgage Loan operations of
ComUnity Lending, Inc., a mortgage bank located in San Jose, California. From
1984 to 1989, Mr. Fry built the operational capacity of Goldome Realty Credit
Corp, a thrift in Buffalo, New York. Mr. Fry received the "Certified Mortgage
Banker" (CMB) designation from the Mortgage Bankers Association of America in
1990 and his Bachelor of Science degree in Real Estate Finance and Economics
from Brigham Young University.
TERRY L. MOTT, age 48, is Executive Vice President of the Company and
serves on the Board of Directors. Mr. Mott joined Mr. Fry in December, 1995, to
form the Company. From 1988 to 1995, Mr. Mott was employed with Medallion
Mortgage Company where, as an Executive Vice President and member of the
company's executive committee, he was responsible for growing the retail and
wholesale production from $5.0 million per month to over $300.0 million per
month in a period of six years. Upon the sale of Medallion Mortgage Company to
AccuBanc Mortgage in 1994, Mr. Mott became an executive vice president at
AccuBanc Mortgage, where he supervised both retail and wholesale branches with
production exceeding $300.0 million per month. From 1980 to 1988, Mr. Mott was
employed with Fleet Mortgage Corp. where he developed and managed the retail and
wholesale production for the western United States. Mr. Mott began his career in
mortgage banking in 1977.
JOHN P. MCMURRAY, CFA, CPA, age 40, joined the Company in February, 1998,
as Executive Vice President of Secondary Marketing and Asset Liability
Management. Prior to joining the Company, Mr. McMurray was President of
Keystroke Financial, Inc., a start-up internet mortgage origination company.
From 1995 to 1996, Mr. McMurray was Executive Vice President and Director, Risk
Management and Capital Markets for Crestar Mortgage Corporation where he was
responsible for interest rate and credit risk management, as well as hedging and
loan sales activities. From 1982 to 1995, Mr. McMurray served in various
management positions with BancPlus Mortgage Corp., most recently serving as
Senior Vice President, Capital Markets. Mr. McMurray is a "Chartered Financial
Analyst" (CFA) and a Certified Public Accountant (CPA). He received a Master of
Science degree in real estate from Massachusetts Institute of Technology, a
Masters of Business Administration degree from the University of Texas, San
Antonio and a Bachelor of Science degree from Trinity University.
STEVEN K. PASSEY, CPA, age 36, is Senior Vice President and Chief Financial
Officer of the Company. Mr. Passey joined the Company in October, 1997, after
eight years with KPMG Peat Marwick LLP ("KPMG"). As a manager at KPMG, Mr.
Passey's responsibilities included managing audits within the
69
<PAGE> 74
financial services area, including the mortgage banking industry. Mr. Passey
received his Bachelor of Science degree in accounting from the University of
Utah and is a Certified Public Accountant (CPA).
CARTER E. JONES, age 55, is an Independent Director of the Company. Since
1990, Mr. Jones has been a Senior Vice President of EVEREN Securities, Inc.,
where he specializes in management of client assets. Mr. Jones has previously
served as a member of the Board of Directors and operating committee for EVEREN
Securities, Inc. From 1987 to 1990, Mr. Jones was Executive Vice President,
Chief Operating Officer and a member of the Board of Directors and the Executive
Committee for Boettcher & Company in Denver.
JEFF K. THREDGOLD, age 46, will become an Independent Director upon
completion of this Offering. Mr. Thredgold is President and Chief Executive
Officer of Thredgold Economic Associates, LLC, and Economic Consulting and
Professional Speaking Company based in Salt Lake City, Utah. Mr. Thredgold's
career includes 23 years with KeyCorp, one of the nation's largest financial
services companies, with assets of nearly $70 billion, where he served as Senior
Vice President and Chief Economist. Mr. Thredgold appears regularly on CNBC-TV
and CNN, and is quoted frequently in The Wall Street Journal, USA Today,
Investor's Business Daily, Fortune and Business Week. Mr. Thredgold is also a
monthly contributor for the national publication, Blue Chip Financial Forecasts
and writes a weekly economic and financial newsletter entitled The Tea Leaf.
DANIEL W. CAMPBELL , age 43, will become an Independent Director upon
completion of this Offering. Mr. Campbell is currently a Managing General
Partner of EsNet, Ltd., a limited partnership engaged in the business of owning,
leasing, managing and developing commercial properties and investing in
companies with high growth potential. From 1992 to 1994, Mr. Campbell was Senior
Vice President and Chief Financial Officer of WordPerfect Corporation. From 1979
to 1992, Mr. Campbell was an associate and then partner at Price Waterhouse,
where he serviced the worldwide accounting and consulting needs of
multi-national Fortune 500 companies.
KEY EMPLOYEES
WAYNE A. MOLL, age 50, is Senior Vice President and Chief Credit Officer.
Mr. Moll has a diverse career experience in loan operations, credit management,
business development, underwriting, lending, loan sales, quality control,
appraising and personnel management. His background includes 30 years in the
lending industry, most recently as Senior Vice President of Fairfield Mortgage
from 1995 through 1996. He was employed as Vice President and Regional Manager
at Colonial Bancorp from 1994 to 1995, and as Vice President and Chief
Underwriter at Medallion Mortgage Company from 1990 to 1994.
VICTOR R. CALANDRA, age 38, is Senior Vice President in charge of
Correspondent lending. Mr. Calandra has over 12 years experience in the mortgage
banking business. Mr. Calandra was formerly a Vice President for Nomura
Securities International ("Nomura") in the fixed income and structured finance
department. At Nomura, Mr. Calandra established nationwide Correspondent
relationships with sellers to Nomura's conduit and was responsible for the
marketing and sale of securities and whole loans acquired through Nomura's home
equity loan conduit.
PATRICK W. CROGHAN, age 38, is Senior Vice President, Wholesale Production
for the eastern United States. His responsibilities include recruiting,
expanding and supervising wholesale branch operations for both Prime and
Subprime Mortgage Loan origination. Mr. Croghan has over ten years of experience
in mortgage banking, all of which has been in loan production. Prior to joining
the Company, he was a Regional Vice President for AccuBanc Mortgage and
Medallion Mortgage.
KENT G. BILLS , age 32, is Senior Vice President, Wholesale Production for
the western United States and the Secretary of the Company. Mr. Bills was
previously a Vice-President with Security National Mortgage Corporation from
1995 through 1996. Prior to joining Security National Mortgage Corporation, he
was Vice President at ComUnity Lending, Inc. in charge of the Company's
wholesale lending operations from 1989 through 1995.
70
<PAGE> 75
WILLIAM J. REED, age 49, is Senior Vice President, Information Systems. Mr.
Reed's primary responsibilities include managing the MIS department, including
software and hardware support for the Company's WAN and the development of a
company-wide integrated software network. Mr. Reed was previously Senior Product
Analyst at Interlinq Software, where he was the lead designer for the
MortgageWare Secondary Marketing System. Prior to that he was Vice President,
Secondary Marketing at Commercial Center Bank, where he established their
correspondent purchase program, and Executive Vice President at Government
Mortgage Corporation, where he established their secondary marketing department.
Mr. Reed has more than 14 years experience in mortgage and mortgage-related
industries.
SHAUNA L. REIMANN, age 42, is Senior Vice President in charge of Retail
Lending. Ms. Reimann has over 20 years of experience in all facets of loan
production and operations, including processing, shipping, warehousing,
underwriting, correspondent lenders and retail originations. She was elected
President of the Utah Mortgage Bankers Association in 1993 and has served on the
Board of Governors for seven years. Prior to joining the Company, she served as
Regional Vice President, Retail Production for AccuBanc and Medallion Mortgage
Companies.
TERMS OF DIRECTORS AND OFFICERS
After this Offering, the Company's Board of Directors will consist of five
persons (as such number may be changed by the Board of Directors from time to
time by resolution) and is divided into three classes, designated Class I, Class
II and Class III, with each class to be as nearly equal in number of directors
as possible. Mr. Fry is a Class III Director, Mr. Mott and Mr. Jones are Class
II Directors. Upon closing of this Offering, Mr. Thredgold and Mr. Campbell will
serve as Class I Directors. Class I, Class II and Class III directors will stand
for reelection at the annual meetings of stockholders held in 1999, 2000 and
2001, respectively. At each annual meeting, the successors to the class of
directors whose term expires at that time are to be elected to hold office for a
term of three years, and until their respective successors are elected and
qualified, so that the term of one class of directors expires at each such
annual meeting. The Company intends to maintain the composition of the Board of
Directors so that there will be no more than seven directors, with a majority of
Independent Directors at all times after the issuance of the Units, each of whom
shall serve on the Audit and/or Compensation Committees. In the case of any
vacancy on the Board of Directors, including a vacancy created by an increase in
the number of directors, the vacancy may be filled by election of the Board of
Directors or the stockholders, with the director so elected to serve until the
next annual meeting of stockholders (if elected by the Board of Directors) or
for the remainder of the term of the director being replaced (if elected by the
stockholders); any newly-created directorships or decreases in directorships are
to be assigned by the Board of Directors so as to make all classes as nearly
equal in number as possible. Directors may be removed only for cause and then
only by vote of a majority of the combined voting power of stockholders entitled
to vote in the election for directors.
The Amended and Restated Articles of Incorporation may be amended by the
vote of a majority of the combined voting power of stockholders, provided that
amendments to the article dealing with directors may only be amended if it is
advised by at least two-thirds of the Board of Directors and approved by vote of
at least two-thirds of the combined voting power of stockholders. The effect of
the foregoing as well as other provisions of the Company's Amended and Restated
Articles of Incorporation and Bylaws may discourage takeover attempts and make
more difficult attempts by stockholders to change management. Prospective
investors are encouraged to review the Amended and Restated Articles of
Incorporation and Bylaws in their entirety.
The Bylaws of the Company provide that, except in the case of a vacancy, a
majority of the members of the Board of Directors will at all times be
Independent Directors. Independent Directors are defined as directors who are
not officers or employees of the Company or any affiliate or subsidiary of the
Company. Vacancies occurring on the Board of Directors among the Independent
Directors may be filled by a vote of a majority of the remaining directors,
including a majority of the remaining Independent Directors. Officers are
elected annually and serve at the discretion of the Board of Directors. There
are no family relationships between the executive officers or directors.
71
<PAGE> 76
COMMITTEES OF THE BOARD
AUDIT COMMITTEE.
The Company has established an Audit Committee composed of three
Independent Directors. The Audit Committee will make recommendations concerning
the engagement of independent auditors, review with the independent auditors the
plans and results of the audit engagement, approve professional services
provided by the independent auditors, review the independence of the independent
auditors, consider the range of audit and non-audit fees and review the adequacy
of the Company's internal accounting controls.
COMPENSATION COMMITTEE.
The Company has established a Compensation Committee composed of two
Independent Directors and John Fry, Chairman of the Board. The Compensation
Committee will determine the compensation of the Company's executive officers.
OTHER COMMITTEES.
The Board of Directors may establish other committees as deemed necessary
or appropriate from time to time, including, but not limited to, an Executive
Committee of the Board of Directors.
COMPENSATION OF DIRECTORS
The Company pays Independent Directors of the Company $10,000 per year plus
$500 for each meeting attended in person. Independent Directors of the Company
also receive automatic stock options pursuant to the Company's Stock Option
Plan. See "-- Executive Compensation -- 1998 Stock Option Plan -- Automatic
Grants to Independent Directors." In addition, each Independent Director will be
granted options to purchase 5,000 shares of Common Stock at the Price to Public
upon the closing of this Offering. In addition, each Independent Director will
receive options to purchase 2,500 shares of Common Stock at the fair market
value of the Common Stock on the day after each annual meeting of stockholders.
All directors receive reimbursement of reasonable out-of-pocket expenses
incurred in connection with meetings of the Board of Directors. No Director who
is an employee of the Company will receive separate compensation for services
rendered as a Director.
COMPENSATION COMMITTEE INTERLOCKS
No interlocking relationship exists between the Company's Board of
Directors or officers responsible for compensation decisions and the board of
directors or compensation committee of any other company, nor has any such
interlocking relationship existed in the past.
EXECUTIVE COMPENSATION
The objective of the Compensation Committee in constructing the
compensation packages of the Company is to align the interests of management as
closely as possible with those of the stockholders. This is accomplished by
basing a large percentage of senior management's compensation on the
profitability of the Company (measured by return on stockholders' equity or
"ROE") and the stock price.
72
<PAGE> 77
BASE COMPENSATION
The base compensation packages for Messrs. Fry, Mott, McMurray and Passey
will be as follows for the terms of their employment agreements (described
below), unless subsequently amended by the Compensation Committee:
<TABLE>
<CAPTION>
ANNUAL COMPENSATION(1)
--------------------------------------------
OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS(2) COMPENSATION
--------------------------- ---- -------- -------- ------------
<S> <C> <C> <C> <C>
John D. Fry...................................... 1996 $ 32,500 $ -0- $ -0-
Chairman of the Board and...................... 1997 $172,500 $ -0- $ -0-
Chief Executive Officer........................ 1998 $250,000 $ (3) $12,000(4)
Terry L. Mott.................................... 1996 $ 16,000 $ -0- $ -0-
Executive Vice President and................... 1997 $138,997 $107,834 $ -0-
Director....................................... 1998 $200,000 $ (5) $ -0-
John P. McMurray................................. 1996 $ -0- $ -0- $ -0-
Executive Vice President of.................... 1997 $ -0- $ -0- $ -0-
Secondary Marketing and........................ 1998 $160,000 $ 40,000(6) $ -0-
Asset Liability Management
Steven K. Passey................................. 1996 $ -0- $ -0- $ -0-
Senior Vice President and...................... 1997 $ 22,195 $ -0- $ -0-
Chief Financial Officer........................ 1998 $120,000 $ (7) $ -0-
</TABLE>
- ---------------
(1) The base compensation packages for 1998 and thereafter will be as presented
for the three- or five-year term of their employment agreements (described
below), unless subsequently amended by the Compensation Committee.
(2) For the fiscal year ended December 31, 1997. For 1998 and beyond, subject to
the Stock Incentive Plan.
(3) Pursuant to his employment agreement, Mr. Fry will receive 33% of the annual
bonus payable under the Bonus Incentive Compensation Plan (the "Annual
Bonus").
(4) Representing a monthly car allowance of $1,000.
(5) Pursuant to his employment agreement, Mr. Mott will receive 20% of the
Annual Bonus.
(6) For 1998, payable upon closing of this Offering. For 1999 and thereafter,
Mr. McMurray will receive 10% of the Annual Bonus up to an amount equal to
his annual base salary.
(7) Pursuant to his employment agreement, Mr. Passey will receive 7% of the
Annual Bonus up to an amount equal to his annual base salary.
BONUS INCENTIVE COMPENSATION PLAN
Upon closing of this Offering, a Bonus Incentive Compensation Plan will be
established for certain executive and key officers of the Company and its
subsidiaries. The annual bonus pursuant to the Bonus Incentive Compensation Plan
(the "Annual Bonus") will be paid one-half in cash and one-half in shares of
Common Stock, annually, following receipt of the audit for the related fiscal
year. This program will award bonuses annually to those officers out of a total
pool determined by stockholder ROE as follows:
<TABLE>
<CAPTION>
ROE(1) IN EXCESS OF BASE RATE(2) BY: ANNUAL BONUS AS PERCENT OF AVERAGE NET WORTH(3) OUTSTANDING
- ------------------------------------ -----------------------------------------------------------
<S> <C>
Zero or less 0%
Greater than 0% but less than 6% 10% * (Actual ROE - Base Rate)
Greater than 6% (10% * 6%) + 15% * (Actual
ROE - (Base Rate + 6%))
</TABLE>
- ---------------
(1) "ROE" is determined for the fiscal year by averaging the monthly ratios
calculated each month by dividing (i) the Company's monthly Net Income
(adjusted to an annual rate) by (ii) its Average Net Worth for such month.
For such calculations, the "Net Income" of the Company means the net income
73
<PAGE> 78
or net loss of the Company determined according to GAAP, after deducting
any dividends paid or payable with respect to preferred stock and before
giving effect to the bonus incentive compensation or any valuation
allowance adjustment to stockholders' equity. The definition "ROE" is used
only for purposes of calculating the bonus incentive compensation payable
pursuant to the Bonus Incentive Compensation Plan, and is not related to
the actual distributions received by stockholders. The bonus payments will
be made before any income distributions are made to stockholders.
(2) "Base Rate" is the average for each month of the 10-Year U.S. Treasury Rate,
plus 4%.
(3) "Average Net Worth" for any month means the arithmetic average of the sum of
(i) the net proceeds from all offerings of equity securities by the Company
since formation including exercise of warrants and stock options and
pursuant to the DRP (but excluding any offerings of preferred stock
subsequent to this Offering), after deducting any underwriting discounts and
commissions and other expenses and costs relating to this Offering, plus
(ii) the Company's retained earnings (without taking into account any losses
incurred in prior fiscal years, after deducting any amounts reflecting
taxable income to be distributed as dividends and without giving effect to
any valuation allowance adjustment to stockholders' equity) computed by
taking the daily average of such values during such period.
Of the amount so determined, one-half will be deemed contributed to the
total pool in cash and the other half deemed contributed to the total pool in
the form of shares of Common Stock, with the number of shares to be calculated
based on the average price per share during the preceding year. Pursuant to
their respective employment agreements, the Company has agreed to pay to Messrs.
Fry, Mott, McMurray and Passey an aggregate of 70% of the Annual Bonus. See
"-- Executive Compensation -- Base Compensation." The remaining Annual Bonus
will be distributed as determined by the Board of Directors or the Compensation
Committee.
EMPLOYMENT AGREEMENTS
The Company has entered into employment agreements with Messrs. Fry, Mott,
McMurray and Passey. The employment agreements with Mr. Fry and Mr. Mott provide
for a five-year term through December, 2002, and the employment agreements with
Mr. McMurray and Mr. Passey provide for a three-year term through December,
2000. Each of the employment agreements will be automatically extended for an
additional year at the end of the initial term and each annual renewal, unless
either party provides a prescribed prior written notice to the contrary. Each
employment agreement provides for the annual base salary set forth in the
compensation table above and for participation by the subject officer in the
Bonus Incentive Compensation Plan. Each employment agreement provides for the
subject officer to receive his annual base salary and bonus compensation to the
date of the termination of employment by reason of death, disability or
resignation and to receive base compensation to the date of the termination of
employment by reason of a termination of employment for cause, as defined in the
agreement. The employment agreements of Messrs. Fry and Mott also provide for
Messrs. Fry and Mott to receive, if Messrs. Fry and Mott are terminated without
cause after a "Change in Control" of the Company as such term is defined in the
agreement, an amount, 50% payable immediately and 50% payable in monthly
installments over the succeeding 12 months, equal to three times their
respective combined maximum base salary and actual bonus compensation for the
preceding year, subject in each case to a maximum amount of one percent of the
Company's book equity value (exclusive of valuation adjustments) but in no case
less than three times their respective base compensation. In addition, all
outstanding options granted to the subject officer under the 1998 Stock Option
Plan shall immediately vest. "Change of Control" for purposes of the agreements
would include a merger or consolidation of the Company, a sale of all or
substantially all of the assets of the Company, changes in the identity of a
majority of the members of the Board of Directors of the Company (other than due
to the death, disability or age of a director) or acquisitions of more than 25%
of the combined voting power of the Company's capital stock, subject to certain
limitations. If the Company terminates any officer's employment without cause,
or, with respect to Mr. Fry, if he resigns for "good reason," the officer
receives a severance amount. The severance amount, which varies from six-months'
base salary to one-year's full base and bonus compensation, is payable
immediately, subject in each case to a maximum amount of one percent of the
74
<PAGE> 79
Company's book value (exclusive of valuation adjustments). If the officer
resigns for any other reason, there is no severance payment. Each of the
officers is prohibited from competing with the Company for a period of two years
following any termination of employment, except upon termination by the Company
without cause.
1996 STOCK OPTION PLAN
The Board of Directors adopted CMG Funding Corp.'s 1996 Stock Option Plan
(the "1996 Plan") pursuant to which options to purchase an aggregate of 226,905
shares of CMG Funding Corp.'s common stock (prior to the reverse stock split
described below) can be granted to officers, directors and employees, and to
consultants, vendors, customers and others expected to provide significant
services to CMG Funding Corp. or its subsidiaries. Upon closing of this
Offering, the Company will adopt CMG Funding Corp.'s 1996 Stock Option Plan and
will convert such options into options to purchase Company Common Stock. If an
option granted under the 1996 Plan expires or terminates, the shares subject to
any unexercised portion of that option will again become available for the
issuance of further options under the applicable plan. Options may be granted
under the 1996 Plan which are intended to qualify as "incentive stock options"
under Section 422 of the Code ("ISOs") or, alternatively, as stock options which
will not so qualify ("NQSOs"). The plans will terminate on December 16, 2006,
and no more options may be granted under the 1996 Plan once it has been
terminated. The Board or a committee designated by the Board is empowered to
determine the terms and conditions of each option granted under the 1996 Plan.
However, the exercise price of an ISO cannot be less than the fair market value
of the Common Stock on the date of grant (110% if granted to an employee who
owns 10% or more of the Common Stock), and the exercise price of an NQSO option
cannot be less than 85% of the fair market value on the date of grant. No option
can have a term in excess of ten years (five years if granted to an employee
owning 10% or more of the Common Stock), and no ISO can be granted to anyone
other than a full-time employee of the Company or its subsidiaries. As of the
date hereof, 69,500 options to purchase shares of CMG Funding Corp. common stock
at an exercise price of $3.96 per share have been granted under the 1996 Plan.
Such options will be reverse split and converted into options to purchase 37,526
shares of Company Common Stock upon the closing of this Offering at an exercise
price of $7.33 per share.
1998 STOCK OPTION PLAN
General. The Company's 1998 Stock Option Plan (the "1998 Stock Option
Plan") provides for the grant of ISOs and NQSOs.
Purpose. The 1998 Stock Option Plan is intended to provide a means of
performance-based compensation in order to attract and retain qualified
personnel and to afford additional incentive to others to increase their efforts
in providing significant services to the Company.
Administration. The 1998 Stock Option Plan will be administered by the
Compensation Committee, which shall at all times be composed solely of
"disinterested persons" as required by Rule 16b-3 under the Exchange Act.
Members of the Compensation Committee and Independent Directors are eligible to
receive only NQSOs pursuant to automatic grants of stock options discussed
below.
Options and Awards. Stock Options granted under the 1998 Stock Option Plan
will become exercisable in accordance with the terms of grant made by the
Compensation Committee. Awards will be subject to the terms and restrictions of
the Awards made by the Compensation Committee. Stock Option and Award recipients
shall enter into a written stock option agreement with the Company. The
Compensation Committee has discretionary authority to select participants from
among eligible persons and to determine at the time a Stock Option or Award is
granted when and in what increments shares covered by the Stock Option or Award
may be purchased or will vest and, in the case of options, whether it is
intended to be an ISO or a NQSO provided, however, that certain restrictions
applicable to ISOs are mandatory, including a requirement that ISOs not be
issued for less than 100% of the then fair market value of the Common Stock
(110% in the case of a grantee who holds more than 10% of the outstanding Common
Stock) and a maximum term of 10 years (five years in the case of a grantee who
holds more than 10% of the outstanding Common Stock). Fair market value means as
of any given date, with respect to any Stock Option or Award granted, at the
discretion of the Board of Directors or the Compensation Committee, (i) the
closing sale price of the Common Stock on such
75
<PAGE> 80
date as reported in the Western Edition of the Wall Street Journal or (ii) the
average of the closing price of the Common Stock on each day of which it was
traded over a period of up to 20 trading days immediately prior to such date, or
(iii) if the Common Stock is not publicly traded (e.g., prior to an initial
public offering), the fair market value of the Common Stock as otherwise
determined by the Board of Directors or the Compensation Committee in the good
faith exercise of its discretion.
Vesting of Options and Awards. The Stock Options granted under the 1998
Stock Option Plan shall vest on the following terms. For each annual period over
a five-year period that the Company delivers a total return (stock price
appreciation, warrant value, appreciation and dividends) to investors in this
Offering equal to or exceeding 20%, one-third of the Stock Options will vest,
until all such Stock Options have vested. Alternatively, if at any time prior to
the end of the five-year period the total return to investors equals or exceeds
100%, all of the Stock Options will vest.
For purposes of calculating the returns to such investors, the term "fiscal
period" will refer to each of five periods, the first commencing with the last
closing of this Offering and ending on December 31, 1999, and each succeeding
fiscal period extending for 12 months and ending on each December 31. The term
"return" for each fiscal period will mean the sum of (on a per share of Capital
Stock basis) (a) all cash dividends paid during (or declared with respect to)
such fiscal period per share of Common Stock, (b) any increase or decrease in
the price per share of Common Stock during such fiscal period, measured by using
the price per share of Capital Stock to investors in this Offering, and using
the average public trading price during the last 90 days of each succeeding
fiscal period for such succeeding periods, and (c) any increase or decrease in
the price per Warrant during such fiscal period, determined in the same manner
as in (b). For purposes of the fiscal period 20% return test, the total return
for a given period will be equal to the sum of (a), (b) and (c) will all be
measured from the beginning of the first fiscal period. The amount of that
"return" will then be measured as a percentage of the investors' investment in
the Units (on a per share of Capital Stock basis) without regard to timing of
receipt of dividends or timing of increases in per share or per Warrant prices.
Automatic grants of Stock Options to the Independent Directors vest 25% on
the anniversary date in the year following the date of the grant and 25% on each
anniversary date thereafter.
Eligible Persons. Officers and directors and employees of the Company and
other persons expected to provide significant services to the Company are
eligible to participate in the 1998 Stock Option Plan. ISOs may be granted to
the officers and key employees of the Company. NQSOs may be granted to the
directors, officers, key employees, agents and consultants of the Company or any
of its subsidiaries.
Under current law, ISOs may not be granted to any director of the Company
who is not an employee, or to directors, officers and other employees of
entities unrelated to the Company. No options may be granted under the Stock
Option Plan to any person who, assuming exercise of all options held by such
person, would own or be deemed to own more than 25% of the outstanding shares of
equity stock of the Company.
Shares Subject to the Plan. Subject to anti-dilution provisions for stock
splits, stock dividends and similar events, the 1998 Stock Option Plan
authorizes the grant of Stock Options to purchase an aggregate of up to 456,667
shares of the Company's Common Stock. If an option granted under the 1998 Stock
Option Plan expires or terminates, the shares subject to any unexercised portion
of such Stock Option will again become available for the issuance of further
Stock Options under the 1998 Stock Option Plan. The maximum number of shares
covered by the 1998 Stock Option Plan will increase (from and after such time as
the number of outstanding shares of Common Stock exceeds the number of shares
outstanding after this Offering) to 10% of the Company's total outstanding
shares at any time.
Term of the Plan. Unless previously terminated by the Board of Directors,
the 1998 Stock Option Plan will terminate on April 1, 2008, and no options may
be granted under the 1998 Stock Option Plan thereafter, but existing options
remain in effect until the options are exercised or terminated by their terms.
Term of Options. Each Stock Option must terminate no more than ten years
from the date it is granted (or five years in the case of ISOs granted to an
employee who is deemed to own an excess of 10% of the combined voting power of
the Company's outstanding equity stock). Stock Options may be granted on terms
76
<PAGE> 81
providing for exercise either in whole or in part at any time or times during
their restrictive terms, or only in specified percentages at stated time periods
or intervals during the term of the Stock Option.
Option Exercise. The exercise price of any Stock Option granted under the
1998 Stock Option Plan is payable in full in cash, or its equivalent as
determined by the Compensation Committee. The Company may make loans available
to option holders to exercise Stock Options evidenced by a promissory note
executed by the option holder and secured by a pledge of Common Stock with fair
value at least equal to the principal of the promissory note unless otherwise
determined by the Compensation Committee.
Automatic Grants to Independent Directors. Each Independent Director of the
Company is automatically granted NQSOs to purchase 5,000 shares of Common Stock
upon becoming a director of the Company, and is also automatically granted NQSOs
to purchase 2,500 shares of Common Stock the day after each annual meeting of
stockholders upon re-election to or continuation on the Board. Such automatic
grants of Stock Options vest 25% on the anniversary date in the year following
the date of the grant and 25% on each anniversary date thereafter. The exercise
price for such automatic grants of Stock Options is the fair market value of the
Common Stock on the date of grant, and is required to be paid in cash.
Amendment and Termination of Stock Option Plan. The Board of Directors may,
without affecting any outstanding Stock Options, from time to time revise or
amend the 1998 Stock Option Plan, and may suspend or discontinue it at any time.
However, no such revision or amendment may, without stockholder approval,
increase the number of shares subject to the 1998 Stock Option Plan, modify the
class of participants eligible to receive options granted under the 1998 Stock
Option Plan or extend the maximum option term under the 1998 Stock Option Plan.
Outstanding Options. Under the Company's 1998 Stock Option Plan, options to
acquire 437,569 shares will be granted upon closing of this Offering. Of these
Stock Options, 15,000 will be granted to the three Independent Directors and
will vest 25% on the closing of this Offering and 25% on each anniversary of
such date thereafter. All Stock Options granted to employees and directors upon
closing of this Offering are exercisable at the Price to Public. The 1998 Stock
Option Plan provides that, in connection with any reorganization, merger,
consolidation, recapitalization, stock split or similar transaction, the
Compensation Committee shall appropriately adjust the number of shares of Common
Stock subject to outstanding Stock Options and the total number of shares for
which Stock Options may be granted under the Plan.
77
<PAGE> 82
STOCK OPTION GRANTS
The following table sets forth information concerning Stock Options granted
during 1997 and to date in 1998 to each member of the Board of Directors and
Executive Officers.
INDIVIDUAL GRANTS
<TABLE>
<CAPTION>
POTENTIAL REALIZABLE VALUE
AT
ASSUMED ANNUAL RATES OF
STOCK
APPRECIATION FOR
PERCENT OF TOTAL OPTIONS EXERCISE PLAN OPTION TERM
GRANTED TO EMPLOYEES OR BASE PICE ---------------------------
NAME GRANT DURING THE YEAR(1) ($/SHARE) DATE 5% ($) 10% ($)
---- ------- ------------------------ ------------- -------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
John D. Fry.......... 126,874 36.4% $ (2) 04/01/98 $1,196,856 $3,033,067
Terry L. Mott........ 39,537 11.4% $ (2) 04/01/98 $ 372,969 $ 945,177
John P. McMurray..... 30,000 8.6% $ (2) 04/01/98 $ 283,003 $ 717,184
Steven K. Passey..... 5,399* 1.6% $7.33 10/27/97 $ 24,888 $ 63,072
5,000 1.4% $ (2) 04/01/98 $ 47,167 $ 119,531
Carter E. Jones...... 5,000 1.4% $ (2) 04/01/98 $ 47,167 $ 119,531
Jeff K. Thredgold.... 5,000 1.4% $ (2) 04/01/98 $ 47,167 $ 119,531
Daniel W. Campbell... 5,000 1.4% $ (2) 04/01/98 $ 47,167 $ 119,531
</TABLE>
- ---------------
* Granted under the 1996 Stock Option Plan.
(1) Calculation of the percentages excludes Stock Options to purchase 126,667
shares of the Company's Common Stock granted to ContiFinancial Corporation.
(2) Exercise price equals the Price to Public.
78
<PAGE> 83
STRUCTURE AND FORMATION TRANSACTIONS
The following discussion is qualified in its entirety by the description of
the potential effects of the 1999 Budget Plan set forth above under
"Business -- Industry Developments."
STRUCTURE OF THE COMPANY
Initially, the Company will conduct its operations through at least two
entities, (i) RealTrust Asset Corporation, a newly-formed Maryland corporation
that will elect REIT status (for purposes of this discussion, sometimes referred
to as "RealTrust"), and (ii) CMG Funding Corp., a Delaware corporation, that
will not elect REIT status (for purposes of this discussion, sometimes referred
to as the "Taxable Subsidiary"). See "Business -- Industry Developments." The
structure is designed primarily to permit RealTrust to acquire the ownership of
95% of the economic interest of the Taxable Subsidiary (including the right to
95% of all dividend distributions) while qualifying for REIT status. See
"Federal Income Tax Considerations -- Qualification as a REIT -- Nature of
Assets."
REALTRUST ASSET CORPORATION
RealTrust Asset Corporation will acquire its portfolio of Mortgage Assets
using the net proceeds of this Offering and the net proceeds of borrowings and
structured debt vehicles. It is anticipated that RealTrust's assets will consist
primarily of Mortgage Assets and the preferred stock of the Taxable Subsidiary.
On [April 1, 1998], the Founders contributed shares of CMG Funding Corp.
preferred stock and common stock for shares of Capital Stock of RealTrust, while
retaining a portion of their shares of the Taxable Subsidiary common stock. The
shares of the Taxable Subsidiary capital stock held by RealTrust were then
recapitalized into shares of non-voting preferred stock, such that RealTrust
owned all of the non-voting preferred stock of the Taxable Subsidiary
representing 95% of the economic interest. The shares of voting common stock of
the Taxable Subsidiary retained by the Founders represent five percent of the
economic interest.
For 1998 and thereafter, RealTrust intends to qualify and elect to be taxed
as a REIT. As a REIT, RealTrust generally will not be taxed on its earnings to
the extent that such earnings are distributed as dividends to its stockholders.
See "Federal Income Tax Considerations -- Taxation of the Company."
THE TAXABLE SUBSIDIARY
The Taxable Subsidiary is a taxable "C" corporation. The Taxable Subsidiary
will not be making a REIT election. The Taxable Subsidiary will perform those
tasks and engage in those lines of business that would result in a loss of REIT
status or the imposition of taxation if RealTrust were to engage in them. In
particular, the Taxable Subsidiary will originate, sell and service Mortgage
Loans and will serve as a source of Mortgage Loans for RealTrust. See "Risk
Factors -- Risks Associated with the Company's Combined Operations and this
Offering -- Potential Effects of 1999 Budget Plan."
RealTrust owns all of the preferred stock of the Taxable Subsidiary
representing 95% of the economic interest but will generally have no right to
control the affairs of the Taxable Subsidiary (other than to approve certain
fundamental transactions such as mergers, consolidations, sales of all or
substantially all of the assets, and voluntary liquidation) because the
preferred stock is non-voting. Instead, the Founders, as the holders of all of
the common stock of the Taxable Subsidiary, control the operations and affairs
of the Taxable Subsidiary. This ownership structure is required because, as a
REIT, RealTrust generally may not own more than 10% of the voting securities of
any other issuer. See "Federal Income Tax Considerations -- Qualification as a
REIT -- Nature of Assets" and "Risk Factors -- Risks Associated with the
Company's Combined Operations and this Offering -- Repeal of Tax-free
Conversions of Corporations into REITs; Effect Upon the Company." Accordingly,
the purchasers of the Units in the Offering will not own an interest in any
entity that controls the Taxable Subsidiary.
The Taxable Subsidiary will make dividend distributions to the extent
consistent with RealTrust's qualification as a REIT. For purposes of receiving
dividends, there is no difference between a share of the
79
<PAGE> 84
preferred stock of the Taxable Subsidiary and a share of the common stock of the
Taxable Subsidiary so that the preferred stock of the Taxable Subsidiary will
have no dividend rate or preference over the common stock of the Taxable
Subsidiary. Instead, dividend distributions by the Taxable Subsidiary will be
made in the same amount per share of the preferred stock of the Taxable
Subsidiary and common stock of the Taxable Subsidiary.
FORMATION TRANSACTIONS
Immediately prior to or upon the closing of this Offering, the following
transactions (the "Formation Transactions") will be consummated:
- The stockholders of the Taxable Subsidiary will have contributed 95% of
their capital stock of the Taxable Subsidiary to RealTrust in exchange
for shares of RealTrust Capital Stock;
- The capital stock of the Taxable Subsidiary will be recapitalized such
that RealTrust will own non-voting preferred stock representing 95% of
the economic interest of the Taxable Subsidiary and the Founders will
own common stock representing five percent of the economic interest of
the Taxable Subsidiary;
- The outstanding shares of preferred stock of RealTrust, owned by
ContiFinancial Corporation, John Fry and Terry Mott, and all of the
shares of Common Stock of RealTrust held by the Founders will be
converted into an aggregate of 1,295,807 shares of Common Stock of
RealTrust, par value $.001 per share (the "Common Stock"); except the
410,581 shares of Class B Redeemable Preferred Stock owned by
ContiFinancial Corporation which will be redeemed after the closing of
this Offering (see "Certain Transactions -- ContiFinancial Corporation"
and "Use of Proceeds");
- The Company will amend its Articles of Incorporation to adopt provisions
necessary for qualification as a REIT;
- The Company will sell 5,000,000 Units in this Offering (assuming no
exercise of the Underwriters' over-allotment option); and
- The Company will grant the Representative's Warrants.
Following the closing of this Offering, the following transactions will be
consummated (the "Post-Closing Transactions"):
- The Company will elect to be taxed as a REIT;
- The Company will conduct certain aspects of its mortgage lending
operations through the Taxable Subsidiary. The Company will own all of
the shares of non-voting preferred stock of the Taxable Subsidiary,
which shares shall represent 95% of the economic interest of the Taxable
Subsidiary. See "Risk Factors -- Risks Associated with the Company's
Combined Operations and this Offering -- Potential Effects of 1999
Budget Plan";
- The Founders will own all of the voting common stock of the Taxable
Subsidiary, which shares shall represent five percent of the economic
interest of the Taxable Subsidiary;
- The Company will redeem the 410,581 shares of Class B Redeemable
Preferred Stock held by ContiFinancial Corporation for $2,000,000, plus
dividends accrued since January 1, 1998, at the rate of 18% per annum;
and
- In addition to the options to purchase 37,526 shares of Common Stock
granted to officers, directors and employees, the Company will also
grant to officers, directors and employees (including ContiFinancial
Corporation) options to purchase an aggregate of 437,569 shares of
Common Stock under the 1998 Stock Option Plan.
80
<PAGE> 85
The consummation of the Formation Transactions and the Post-Closing
Transactions will have the following consequences:
- The purchasers of Units in this Offering will own 79.4% of the
outstanding shares of Common Stock (assuming no exercise of the
Warrants, the Representative's Warrants, the over-allotment option or
outstanding stock options) and will own all of these Warrants, except
the Representative's Warrants;
- The Founders will collectively own 20.6% of the outstanding shares of
Common Stock outstanding (assuming no exercise of the Warrants, the
Representative's Warrants, the over-allotment option or outstanding
stock options);
- In addition to options granted to officers, directors and employees of
the Company to purchase 37,526 shares of Common Stock at an exercise
price of $7.33, officers, directors and employees of the Company
(including ContiFinancial Corporation) will have options to purchase an
aggregate of 437,569 shares of Common Stock, subject to certain vesting
provisions, at an exercise price equal to the Price to Public;
- The Company will own all of the non-voting preferred stock of the
Taxable Subsidiary, which shares will represent 95% of the economic
interest of the Taxable Subsidiary; and
- The Founders will own all of the voting shares of common stock of the
Taxable Subsidiary, which stock will represent five percent of the
economic value of the Taxable Subsidiary.
CERTAIN TRANSACTIONS
CONTIFINANCIAL CORPORATION
CMG Funding Corp., the Taxable Subsidiary, has entered into several
transactions with ContiFinancial Corporation. Certain obligations of the Taxable
Subsidiary will terminate upon closing of this Offering, and certain others will
be assumed by the Company and will continue after the closing of this Offering.
Stock Ownership. Immediately prior to the closing of this Offering,
ContiFinancial Corporation will own 546,883 shares of Common Stock, 252,117
shares of Class A Convertible Preferred Stock and 410,581 shares of Class B
Redeemable Preferred Stock, which in the aggregate represents approximately
43.0% of the outstanding shares of Capital Stock (approximately 42.0% on a fully
diluted basis). Immediately prior to the closing of this Offering, each share of
Class A Convertible Preferred Stock, including those owned by ContiFinancial
Corporation, will be converted into one share of Common Stock. All of the
outstanding shares of Common Stock will be reverse split into an aggregate of
1,295,807 shares of Common Stock. As a result, immediately prior to the closing
of this Offering, ContiFinancial Corporation will own 431,418 shares of Common
Stock, representing 33.3% of the outstanding shares (32.4% on a fully diluted
basis). Upon closing of this Offering, the Company intends to redeem the Class B
Redeemable Preferred.
The redemption price for all shares of the Class B Redeemable Preferred
Stock equals the original purchase price of $2,000,000, plus dividends accrued
from January 1, 1998 at the rate of 18% per annum, for a total redemption price
of $2,180,000, assuming redemption occurs on June 30, 1998. The Class B
Redeemable Preferred Stock is also entitled to a liquidation preference of
$2,000,000 plus accrued dividends. The Class B Redeemable Preferred Stock is not
convertible into Common Stock.
Agreements to Sell Mortgage Loans. Upon the closing of this Offering until
December 31, 2001, the Taxable Subsidiary has agreed to sell to ContiFinancial
Corporation not less than 75% of the fixed rate Subprime Mortgage Loans
originated or acquired by the Taxable Subsidiary in each month. The purchase
price for such Subprime Mortgage Loans shall be the fair market value for such
Mortgage Loans as determined by the best published rate sheet at ContiMortgage
Corporation, an affiliate of ContiFinancial Corporation. In any month, the
Taxable Subsidiary may substitute adjustable-rate Subprime Mortgage Loans for up
to 50% of the amount required to be offered for sale to ContiFinancial
Corporation. To the extent that the Taxable Subsidiary offers to sell less than
75% of the monthly fixed rate Subprime Mortgage Loan
81
<PAGE> 86
production, the Taxable Subsidiary has agreed to pay ContiFinancial Corporation
a fee equal to 40 basis points multiplied by the amount of the principal
shortfall.
Warehouse, Standby and Working Capital Financing Agreements. The Taxable
Subsidiary currently has a warehouse facility with ContiFinancial Corporation in
the principal amount of $50.0 million and a working capital facility in the
maximum principal amount of $2.0 million. As of February 28, 1998, the Company
had outstanding borrowings under such lines of $46.4 million and $1.8 million,
respectively. The Company anticipates that, immediately after the closing of
this Offering, the Company will repay all amounts borrowed under the working
capital facility. See "Use of Proceeds." The Taxable Subsidiary may continue to
finance the acquisition of Mortgage Loans under the warehouse facility. Although
the Company anticipates that it will be able to obtain financing more favorable
than the warehouse facility after the closing of this Offering, the Company
believes that the warehouse facility is currently on terms not less favorable to
the Company than those available from independent third parties in arm's-length
transactions.
Warrants to Purchase Capital Stock. The Taxable Subsidiary has granted to
ContiFinancial Corporation two warrants to purchase shares of common stock. If
the amount of principal and interest due under the working capital facility is
not repaid in full by January 1, 1999, the first warrant allows ContiFinancial
Corporation to purchase, for a nominal amount, shares of common stock
representing up to five percent of the outstanding shares (on a fully diluted
basis) of the Taxable Subsidiary. If the Company repays in full the working
capital facility, the warrant is not exercisable and automatically terminates.
The Company anticipates that the working capital facility will be repaid upon
closing of this Offering from the net proceeds thereof. See "Use of Proceeds."
The Taxable Subsidiary has also granted ContiFinancial Corporation a
warrant to purchase, for a nominal amount, shares of common stock representing
one percent of the outstanding shares (on a fully diluted basis) for each
quarter in which the Taxable Subsidiary does not attain at least 90% of its
pre-tax net income target. Such warrant automatically expires and may not be
exercised by ContiFinancial Corporation after the closing of this Offering. The
Taxable Subsidiary has established the pre-tax net income targets.
Structured Debt Placement Agent/Underwriter. Until December 2001, the
Company has appointed ContiFinancial Corporation as its exclusive placement
agent for structured debt offerings and other securitizations and has agreed to
pay to ContiFinancial Corporation a fee of 25 basis points of the principal
amount of any such structured debt public offering and 50 basis points of the
gross proceeds of any such structured debt private offering. Such fee is payable
to ContiFinancial Corporation for financial advisory services to be rendered
pursuant to the applicable contract and will not be reduced by any fees payable
or paid to others, including the underwriters, the placement agent or to other
agents or advisors, if any, in connection with any structured debt offering. See
"Certain Transactions -- ContiFinancial Corporation" and "Risk Factors -- Risks
Associated with the Acquisition and Management of a Portfolio of Mortgage Assets
-- Dependence Upon Structured Debt Financing Market and Credit Enhancements;
Potential Increased Cost of Agreement with ContiFinancial Corporation."
CAPSTONE INVESTMENTS, INC.
In March, 1998, the Taxable Subsidiary borrowed $850,000 from Capstone
Investments, Inc. ("Capstone"), a Nevada corporation, the sole shareholders of
which are Founders David and Sarah Ferradino. The loan is evidenced by a
Convertible Secured Promissory Note (the "Note") bearing simple interest at 9%
per annum and maturing upon the earlier of the following to occur: (i) January
1, 1999, or (ii) the completion of this Offering. The Note is secured by a
pledge of Company Common Stock by certain of the Founders. Upon completion of
this Offering, Capstone will have the option to convert all or any portion of
the Note into a number of Units determined by dividing the amount to be
converted by the Price to Public. The Company also has granted Capstone warrants
to purchase 50,000 shares of the Company's Common Stock. The warrants have an
exercise price equal to the Price to Public and expire three years from their
grant date. The Company believes that the terms of the Note and warrants are no
less favorable to the Company than those available from an independent
third-party in an arm's-length transaction.
82
<PAGE> 87
FORMATION TRANSACTIONS
The Formation Transactions that will occur on or prior to the first closing
date of this Offering will benefit the Founders of the Company. See "Structure
and Formation Transactions."
EMPLOYMENT AGREEMENTS
The Company will enter into employment agreements with each of Messrs. Fry,
Mott, McMurray and Passey. Such employment agreements will provide for an
initial term of five years for Messrs. Fry and Mott and three years for Messrs.
McMurray and Passey, among other benefits. See "Management -- Executive
Compensation -- Employment Agreements."
83
<PAGE> 88
PRINCIPAL STOCKHOLDERS
The following table sets forth certain information regarding the beneficial
ownership of the Company's Common Stock as of December 31, 1997, adjusted to
give effect to the Formation Transactions, of: (i) each of the Company's
directors and executive officers, (ii) each person who beneficially owns more
than five percent of the outstanding shares of Capital Stock, and (iii) all
directors and officers of the Company as a group.
<TABLE>
<CAPTION>
PERCENTAGE OF SHARES OF COMMON
NUMBER OF SHARES STOCK BENEFICIALLY OWNED
OF COMMON STOCK ---------------------------------------
NAME BENEFICIALLY OWNED(1) BEFORE OFFERING AFTER OFFERING(1)(2)
---- --------------------- --------------- --------------------
<S> <C> <C> <C>
ContiFinancial Corporation(3)........ 431,418 33.3% 6.9%
John D. Fry.......................... 392,798 30.3% 6.2%
Terry L. Mott........................ 122,406 9.4% 1.9%
Steven K. Passey(4).................. 5,399 * *
All executive officers and directors
as a group (3 persons)............. 520,603 40.2% 8.3%
</TABLE>
- ---------------
* Less than one percent.
(1) Excludes options available for grant under the 1998 Stock Option Plan to
purchase an aggregate of up to 456,667 shares of Common Stock.
(2) Assuming no exercise of outstanding Warrants or the Representative's
Warrants.
(3) Excludes 410,581 shares of Class B Redeemable Preferred Stock which the
Company intends to redeem upon the closing of this Offering. See "Certain
Transactions -- ContiFinancial Corporation."
(4) Includes options to purchase 5,399 shares of Common Stock exercisable at
$7.33 per share granted under the 1996 Stock Option Plan which are
immediately exercisable.
DESCRIPTION OF CAPITAL STOCK
GENERAL
Upon the closing of this Offering, the authorized capital stock of the
Company will consist of 100,000,000 shares of Common Stock, of which 6,295,807
will be outstanding and 5,000,000 shares of preferred stock, none of which will
be outstanding.
HISTORICAL CAPITAL STRUCTURE
Prior to the closing of this Offering and the consummation of the Formation
Transactions (see "Structure and Formation Transactions"), the Company was
authorized to issue 2,609,407 shares of Common Stock, of which 1,546,983 were
outstanding, 1,268,950 shares of Class A Convertible Preferred Stock, of which
852,891 were outstanding and 410,581 shares of Class B Redeemable Preferred
Stock, all of which were outstanding. In addition, the Company had granted
options to purchase 69,500 shares of Common Stock at an exercise price of $3.96
per share. As a result of the Formation Transactions, the outstanding shares of
Class A Convertible Preferred Stock will be converted on a one-for-one basis
into shares of Common Stock and such shares of Class A Convertible Preferred
Stock will be cancelled. The total number of outstanding shares of Common Stock,
including the options granted under the 1996 Stock Option Plan, at such time
will be 2,469,374. The Common Stock will then be reverse split at a ratio of
approximately .54 shares for 1 immediately prior to the closing. As a result of
such split, the number of shares owned by the Founders, including shares
issuable upon exercise of the options granted under the 1996 Stock Option Plan
but excluding the Class B Redeemable Preferred Stock, after this Offering will
be 1,333,333 shares. Immediately after the closing, the Class B Redeemable
Preferred Stock will be redeemed for $2,000,000, plus accrued dividends.
The following summary of the respective rights of the Common Stock and the
preferred stock is qualified in its entirety by reference to the Company's
Amended and Restated Articles of Incorporation.
84
<PAGE> 89
\COMMON STOCK
VOTING
Each holder of Common Stock is entitled to one vote for each share of
record on each matter submitted to a vote of holders of Capital Stock of the
Company. The Company's Amended and Restated Articles of Incorporation do not
provide for cumulative voting and, accordingly, the holders of a majority of the
outstanding shares of Capital Stock have the power to elect all directors to be
elected each year.
Annual meetings of the stockholders of the Company will be held, and
special meetings may be called by any member of the Board of Directors, by the
President or generally by stockholders holding at least 20% of the outstanding
shares of Capital Stock entitled to be voted at the meeting. The Amended and
Restated Articles of Incorporation of the Company may be amended in accordance
with Maryland law, subject to certain limitations set forth in the Amended and
Restated Articles of Incorporation.
DIVIDENDS; LIQUIDATION; OTHER RIGHTS
The holders of shares of Common Stock are entitled to receive dividends
when, as, and if declared by the Board of Directors out of funds legally
available therefor. In the event of liquidation, dissolution or winding up of
the Company, the holders of Common Stock will share ratably in all assets of the
Company remaining after the payment of liabilities and after payment of the
liquidation preference of any shares or series of preferred stock that may be
issued. There are no preemptive or other subscription rights, conversion rights
or redemption or sinking fund provisions with respect to shares of Common Stock.
PREFERRED STOCK
The Company's Board of Directors is authorized by the charter to fix or
alter the rights, preferences, privileges and restrictions of any series of
preferred stock, including the dividend rights, original issue price, conversion
rights, voting rights, terms of redemption, liquidation preferences and sinking
fund terms thereof, and the number of shares of such series subsequent to the
issuance of shares of such series (but not below the number of shares
outstanding). As the terms of the preferred stock can be fixed by the Board of
Directors without shareholder action, the Board of Directors may issue preferred
stock with terms calculated to defeat a proposed takeover of the Company or to
make the removal of management more difficult. The Board of Directors, without
shareholder approval, could issue preferred stock with dividend, voting,
conversion and other rights which could adversely affect the rights of the
holders of Common Stock. The Company's Board of Directors currently has no plans
to issue shares of preferred stock in the Company. See "Risk Factors -- Risks
Associated with the Company's Combined Operations and this Offering -- Issuance
of Preferred Stock."
WARRANTS AND OPTIONS
Under the 1996 Stock Option Plan, the Company has granted options to
purchase an aggregate of 69,500 shares at an exercise price of $3.96 per share.
As a result of the reverse stock split described in "Structure and Formation
Transactions," such options will be converted into options to purchase a total
of 37,526 shares of Common Stock at an exercise price of $7.33 per share. All of
such options are immediately exercisable.
Under the 1998 Stock Option Plan, the Company will issue options to
purchase a total of 437,569 shares of Common Stock at a price equal to the Price
to Public. None of such options are currently exercisable, and are subject to
the vesting provisions set forth in the Company's 1998 Stock Option Plan. See
"Management -- Executive Compensation -- 1998 Stock Option Plan."
Each Unit consists of one share of Common Stock and one Warrant. Prior to
automatic separation of the related Warrant, the Units will be represented by
the Common Stock, which will bear an endorsement representing beneficial
ownership of the related Warrants on deposit with the Warrant Agent (as defined
below) as custodian for the registered holders of the Common Stock. Prior to
automatic separation, transfer of a share of Common Stock to which the related
Warrant has not been exercised will also constitute transfer of a holder's
beneficial interest in the related Warrant. The Warrants to be issued to the
Representative will be evidenced by a Warrant Certificate at the time initially
issued. The Warrants are exercisable beginning six
85
<PAGE> 90
months following the closing of this Offering and will remain exercisable until
5:00 p.m. Eastern Time on the third anniversary of the date the Warrants first
become exercisable (the "Expiration Date"), at an exercise price equal to the
Price to Public per share. At 5:00 p.m. Eastern Time on the Expiration Date the
Warrants will become wholly void and of no value.
The Warrants will be issued pursuant to a warrant agreement (the "Warrant
Agreement") dated as of the initial closing of this Offering between the Company
and the warrant agent (the "Warrant Agent"). The Company's stock transfer agent,
American Securities Transfer & Trust Incorporated, will initially act as Warrant
Agent. The following summary of certain provisions of the Warrant Agreement does
not purport to be complete and is qualified in its entirety by reference to the
Warrant Agreement including the definitions therein of certain terms used below.
A copy of the proposed form of Warrant Agreement is available from the Company
upon request and is filed as an exhibit to the Registration Statement of which
this Prospectus is a part. See "Additional Information.".
Each Warrant, when exercised, will entitle the holder thereof to receive
one share (subject to certain adjustments) of Common Stock at an exercise price
equal to the Price to Public (the "Exercise Price").
Initial delivery of the Securities from the Company to the Underwriters is
expected to occur through the book-entry facilities of The Depository Trust
Company ("DTC"). See "-- Book Entry Issuance" below. Thereafter, a beneficial
owner of such book-entry Securities (a "Beneficial Owner") will be entitled to
receive physical delivery of certificates representing its Securities only in
accordance with procedures established among DTC and its Direct and Indirect
Participants (as defined below), and in accordance with procedures, if any,
established between the Beneficial Owner and the Direct or Indirect Participant
through which the Beneficial Owner holds an interest in the Securities.
The Warrants, held in certificated form, may be exercised by surrendering
to the Warrant Agent the definitive Warrant Certificate evidencing such
Warrants, with the accompanying form of election to purchase properly completed
and executed, together with payment of the exercise price which initially equals
the Price to Public, subject to adjustment (the "Exercise Price").
Warrants held in book-entry form may be exercised only in accordance with
procedures established among DTC and its Direct and Indirect Participants.
Pursuant thereto, a Beneficial Owner wishing to exercise a Warrant shall give
notice, through its Participant, to the Warrant Agent, and shall effect delivery
of the Warrant by causing the Direct Participant to transfer the Participant's
interest in the Warrant, on DTC's records, to the Warrant Agent. The requirement
for physical delivery of the Warrant in connection with the exercise thereof
will be deemed satisfied when the ownership rights in the Warrant are
transferred by Direct Participants on DTC's records and followed by a book-entry
credit of the tendered Warrant to the Warrant Agent's account.
Payment of the Exercise Price may be made (a) in the form of cash or by
certified or official bank check payable to the order of the Company, or (b) by
surrendering additional Warrants or shares of Common Stock for cancellation to
the extent the Company may lawfully accept shares of Common Stock, with the
value of such shares of Common Stock for cancellation to the extent the Company
may lawfully accept shares of Common Stock, with the value of such shares of
Common Stock for such purpose to equal the average trading price of the Common
Stock during the 10 trading days preceding the date surrendered and the value of
the Warrants to equal the difference between the value of a share of Common
Stock and the Exercise Price, or (c) pursuant to such other payment procedures
as may be established by the Warrant Agent from time to time in accordance with
the Warrant Agreement. Upon surrender of the Warrant Certificate and payment of
the Exercise Price and any other applicable amounts, the Warrant Agent will
deliver or cause to be delivered, to or upon the written order of such holder or
its DTC Participant, stock certificates or DTC book-entry positions representing
the number of whole shares of Common Stock or other securities or property to
which such holder is entitled. If less than all of the Warrants evidenced by a
Warrant Certificate are to be exercised, a new Warrant Certificate will be
issued for the remaining number of Warrants.
Both (a) the initial sale of the Warrants, and (b) the issuance of the
underlying shares of Common Stock upon exercise of the Warrants, have been
registered by the Company under the Securities Act of 1933, as
86
<PAGE> 91
amended, pursuant to the Registration Statement of which this Prospectus is a
part. The Company has applied to have the Warrants approved for listing on the
American Stock Exchange. If a market for the Warrants develops, a Warrant holder
may choose to sell the Warrants instead of exercising them. There can be no
assurance that the American Stock Exchange, or any other market, will list the
Warrants or that a market for the Warrants will develop or continue.
No fractional shares of Common Stock will be issued upon exercise of the
Warrants. The holders of the Warrants have no right to vote on matters submitted
to the stockholders of the Company and have no right to receive dividends. The
holders of the Warrants not yet exercised are not entitled to share in the
assets of the Company in the event of liquidation, dissolution or the winding up
of the affairs of the Company.
Additionally, in March, 1998, the Company granted warrants to purchase
50,000 shares of Common Stock to Capstone Investments, Inc. ("Capstone"), in
connection with Capstone's $850,000 loan to the Company. See "Certain
Transactions -- Capstone Investments, Inc."
The Company has also agreed to issue, to the Representative, Warrants to
purchase shares of Common Stock equal to three percent of the Units sold in this
Offering at an exercise price equal to the Price to Public.
ADJUSTMENTS
The Exercise Price of the Warrants will be appropriately adjusted if the
Company (i) pays a dividend or makes a distribution on its Common Stock in
shares of its Common Stock; (ii) subdivides its outstanding shares of Common
Stock into a greater number of shares, (iii) combines its outstanding shares of
Common Stock into a smaller number of shares, (iv) issues by reclassification of
its Common Stock any shares of its Capital Stock, or (v) issues shares of
Capital Stock at a price below the greater of (a) the Price to Public or (b)
fair market value, provided that this clause (v) shall not apply to firm
underwriting offerings.
In case of certain consolidations or mergers of the Company, or the
liquidation of the Company or the sale of all or substantially all of the assets
of the Company to another corporation, each Warrant will thereafter be deemed
exercised for the right to receive the kind and amount of shares of stock or
other securities or property to which such holder would have been entitled as a
result of such consolidation, merger or sale had the Warrants been exercised
immediately prior thereto, less the Exercise Price.
BOOK-ENTRY ISSUANCE -- THE DEPOSITORY TRUST COMPANY
The Depository Trust Company will act as securities depository for a
portion of the Securities. One or more fully registered Common Stock
certificates representing such Securities will be registered in the name of DTC
or its nominee. Upon the detachment of the related Warrants, one or more Warrant
Certificates will be issued in the name of DTC or its nominee.
DTC is a limited-purpose trust company organized under the New York Banking
Law, a "banking organization" within the meaning of the New York Banking Law, a
member of the Federal Reserve System, a "clearing corporation" within the
meaning of the New York Uniform Commercial Code, and a "clearing agency"
registered pursuant to the provisions of Section 17A of the Exchange Act. DTC
holds securities that its participants ("Participants") deposit with DTC. DTC
also facilitates the settlement among Participants of securities transactions,
such as transfers and pledges, in deposited securities through electronic
computerized book-entry changes in Participants' accounts, thereby eliminating
the need for physical movement of securities certificates. Direct Participants
include securities brokers and dealers, banks, trust companies, clearing
corporations, and certain other organization ("Direct Participants"). DTC is
owned by a number of its Direct Participants and by the New York Stock Exchange,
the American Stock Exchange, Inc., and the National Association of Securities
Dealers, Inc. Access to the DTC system is also available to others such as
securities brokers and dealers, banks and trust companies that clear through or
maintain a custodial relationship with a Direct Participant, either directly or
indirectly ("Indirect Participants"). The rules applicable to DTC and its
Participants are on file with the Securities and Exchange Commission.
Upon issuance of a Warrant Certificate in the name of DTC or its nominee,
DTC will credit on its book-entry registration and transfer system the number of
Warrants represented by such Warrant Certificate to the
87
<PAGE> 92
accounts of institutions that have accounts with DTC. Ownership of beneficial
interests in such a Warrant Certificate will be limited to Participants or
persons that may hold interests through Participants. The ownership interest of
each actual purchaser of such Warrant ("Beneficial Owner") is in turn to be
recorded on the Direct and Indirect Participants' records. Beneficial Owners
will not receive written confirmation from DTC of their purchases, but
Beneficial Owners are expected to receive written confirmations providing
details of the transactions, as well as periodic statements of their holdings,
from the Direct or Indirect Participants through which the Beneficial Owners
purchased Warrants. Transfers of ownership interests in the Warrants are to be
accomplished by entries made on the books of Participants acting on behalf of
Beneficial Owners.
DTC has no knowledge of the actual Beneficial Owners of such Warrants;
DTC's records reflect only the identity of the Direct Participants to whose
accounts such Warrants are credited, which may or may not be the Beneficial
Owners. The Participants will remain responsible for keeping account of their
holdings on behalf of their customers. So long as DTC, or its nominee, is the
owner of such Warrant Certificate, DTC or such nominee, as the case may be, will
be considered the sole owner and holder of record of the Warrants represented by
such Warrant Certificate for all purposes.
Conveyance of notices and other communications by DTC to Direct
Participants, by Direct Participants to Indirect Participants, and by Direct
Participants and Indirect Participants to Beneficial Owners will be governed by
arrangements among them, subject to any statutory or regulatory requirements as
may be in effect from time to time.
The information in this section concerning DTC and DTC's book-entry system
has been obtained from sources that the Company believes to be reliable but the
Company takes no responsibility for the accuracy of such information. In
addition, the Company has no responsibility for the performance by DTC or its
Participants of their respective obligations as described hereunder or under the
rules and procedures governing their respective operations.
REPURCHASE OF SHARES AND RESTRICTION ON TRANSFER
Two of the requirements for qualification for the tax benefits accorded by
the REIT provisions of the Code are that for all taxable years of the REIT after
the first taxable year for which its REIT election is made (1) during the last
half of each such taxable year not more than 50% in value of the outstanding
shares may be owned directly or indirectly by five or fewer individuals (the
"50%/5 stockholder test") and (2) there must be at least 100 stockholders on 335
days of each such taxable year of 12 months and during a proportionate part
during any such shorter taxable year.
In order that the Company may meet these requirements at all times, the
Amended and Restated Articles of Incorporation prohibit any person from
acquiring or holding, directly or indirectly, shares of Capital Stock in excess
of 9.8% in value of the aggregate of the outstanding shares of Capital Stock or
in excess of 9.8% (in value or in number of shares, whichever is more
restrictive) of the aggregate of the outstanding shares of Common Stock of the
Company. For this purpose, the term "ownership" is defined in accordance with
the REIT provisions of the Code and the constructive ownership provisions of
Section 544 of the Code, as modified by Section 856(h)(1)(B) of the Code.
For purposes of the 50%/5 stockholder test, the constructive ownership
provisions applicable under Section 544 of the Code attribute ownership of
securities owned by a corporation, partnership, estate or trust proportionately
to its stockholders, partners or beneficiaries, attribute ownership of
securities owned by family members and partners to other members of the same
family, treat securities with respect to which a person has an option to
purchase as actually owned by that person, and set forth rules as to when
securities constructively owned by a person are considered to be actually owned
for the application of such attribution provisions (i.e., "reattribution").
Thus, for purposes of determining whether a person holds shares of Capital Stock
in violation of the ownership limitations set forth in the Amended and Restated
Articles of Incorporation, many types of entities may own directly more than the
9.8% limit because such entities' shares are attributed to its individual
stockholders. On the other hand, a person will be treated as owning not only
shares of Capital Stock actually or beneficially owned, but also any shares of
Capital Stock attributed to such person under the attribution rules described
above. Accordingly, under certain circumstances, shares of Capital Stock owned
by a person who
88
<PAGE> 93
individually owns less than 9.8% of the shares outstanding may nevertheless be
in violation of the ownership limitations set forth in the Amended and Restated
Articles of Incorporation. Ownership of shares of the Company's Capital Stock
through such attribution is generally referred to as constructive ownership. The
100 stockholder test is determined by actual, and not constructive, ownership.
Notwithstanding any of the foregoing ownership limits, no holder may own or
acquire, either directly or constructively under the applicable attribution
rules of the Code, any shares of any class of the Company's Capital Stock if
such ownership or acquisition (i) would cause more than 50% in value of the
Company's outstanding stock to be owned, either directly or constructively under
the applicable attribution rules of the Code, by five or fewer individuals (as
defined in the Code to include certain tax-exempt entities, other than, in
general, qualified domestic pension funds), (ii) would result in the Company's
Capital Stock being beneficially owned by less than 100 persons (determined
without reference to any rules of attribution), or (iii) would otherwise result
in the Company failing to qualify as a REIT.
The Board of Directors may, subject to the receipt of certain
representations and a ruling from the Service or an opinion of counsel
satisfactory to it, waive the ownership restrictions with respect to a holder if
such waiver will not jeopardize the Company's status as a REIT. In addition,
under the Amended and Restated Articles of Incorporation, certain parties will
not be subject to the stock ownership limit in the event such parties (i)
deliver to the Company either a ruling from the Service or an opinion from
counsel satisfactory to the Company that such ownership will result in no
individual (as defined in the Code) beneficially or constructively owning in
excess of 9.8% of the outstanding common stock and (ii) represent to the Company
that it does not and will not own more than a 9.8% interest in any tenant of the
Company.
If any stockholder purports to transfer Capital Stock to a person and
either the transfer would result in the Company failing to qualify as a REIT or
such transfer would cause the transferee to hold capital stock in excess of an
applicable ownership restriction, the purported transfer shall be null and void,
the intended transferee will acquire no rights or economic interest in the
capital stock and the stockholder will be deemed to have transferred the capital
stock to the Company in exchange for Excess Stock of the same class or classes
as were purportedly transferred, which Excess Stock will be deemed to be held by
the Company as trustee of a trust for the exclusive benefit of the person or
persons to whom the shares can be transferred without violating the ownership
restrictions. In addition, if any person owns, either directly or constructively
under the applicable attribution rules of the Code, shares of Capital Stock in
excess of an applicable ownership restriction, such person will be deemed to
have exchanged the shares of Capital Stock that cause the applicable ownership
restriction to be exceeded for an equal number of shares of Excess Stock of the
appropriate class, which will be deemed to be held by the Company as trustee of
a trust for the exclusive benefit of the person or persons to whom the shares
can be transferred without violating the ownership restrictions. A person who
holds or transfers shares such that shares of capital stock shall have been
deemed to be exchanged for Excess Stock will not be entitled to vote the Excess
Stock and will not be entitled to receive any dividends or distributions (any
dividend or distribution paid on shares of capital stock prior to the discovery
by the Company that such shares have been exchanged for Excess Shares shall be
repaid to the Company upon demand, and any dividend or distribution declared but
unpaid shall be rescinded). Such person shall have the right to designate a
transferee of such Excess Stock so long as consideration received for
designating such transferee does not exceed a price (the "Limitation Price")
that is equal to the lesser of (i) in the case of a deemed exchange for Excess
Stock resulting from a transfer, the price paid for such shares in the transfer
or, in the case of a deemed exchange for Excess Stock resulting from some other
event, the fair market value on the date of the deemed exchange, of the shares
deemed exchanged, or (ii) the fair market value of the shares for which such
Excess Stock will be deemed to be exchanged on the date of the designation of
the transferee (or, in the case of a purchase by the Company, on the date the
Company accepts the offer to sell). The shares of Excess Stock so transferred
will automatically be deemed reexchanged for the appropriate shares of capital
stock. In addition, the Company will have the right to purchase the Excess Stock
for a period of 90 days at a price equal to the Limitation Price.
If the foregoing transfer restrictions are determined to be void or invalid
by virtue of any legal decisions, statute, rule or regulation, then the intended
transferee of any Excess Stock may be deemed, at the option of
89
<PAGE> 94
the Company, to have acted as an agent on behalf of the Company in acquiring
such Excess Stock and to hold such Excess Stock on behalf of the Company.
The Amended & Restated Articles of Incorporation further provide that if
any transfer of shares of Capital Stock occurs which, if effective, would result
in any person beneficially or constructively owning shares of Capital Stock in
excess or in violation of the above transfer or ownership limitations, then that
number of shares of Capital Stock the beneficial or constructive ownership of
which otherwise would cause such person to violate such limitations (rounded to
the nearest whole shares) shall be automatically transferred to a trustee (the
Trustee) as trustee of a trust (the Trust) for the exclusive benefit of one or
more charitable beneficiaries (the "Charitable Beneficiary"), and the intended
transferee shall not acquire any rights in such shares. Shares held by the
Trustee shall be issued and outstanding shares of Capital Stock. The intended
transferee shall not benefit economically from ownership of any shares held in
the Trust, shall have no rights to dividends, and shall not possess any rights
to vote or other rights attributable to the shares held in the Trust. The
Trustee shall have all voting rights and rights to dividends or other
distributions with respect to shares held in the Trust, which rights shall be
exercised for the exclusive benefit of the Charitable Beneficiary. Any dividend
or other distribution paid to the intended transferee prior to the discovery by
the Company that shares of Common Stock have been transferred to the Trustee
shall be paid with respect to such shares to the Trustee by the intended
transferee upon demand and any dividend or other distribution authorized but
unpaid shall be paid when due to the Trustee. The Board of Directors may, in
their discretion, waive these requirements on owning shares in excess of the
ownership limitations.
Within 20 days of receiving notice from the Company that shares of Capital
Stock have been transferred to the Trust, the Trustee shall sell the shares held
in the Trust to a person, designated by the Trustee, whose ownership of the
shares will not violate the ownership limitations set forth in the Charter. Upon
such sale, the interest of the Charitable Beneficiary in the shares sold shall
terminate and the Trustee shall distribute the net proceeds of the sale to the
intended transferee and to the Charitable Beneficiary as follows. The intended
transferee shall receive the lesser of (1) the price paid by the intended
transferee for the shares or, if the intended transferee did not give value for
the shares in connection with the event causing the shares to be held in the
Trust (e.g., in the case of a gift, devise or other such transaction), the
market price (as defined in the Company's Amended and Restated Articles of
Incorporation) of the shares on the day of the event causing the shares to be
held in the Trust and (2) the price per share received by the Trustee from the
sale or other disposition of the shares held in the Trust. Any net sales
proceeds in excess of the amount payable to the intended transferee shall be
immediately paid to the Charitable Beneficiary. In addition, shares of Capital
Stock transferred to the Trustee shall be deemed to have been offered for sale
to the Company, or its designee, at a price per share equal to the lesser of (i)
the price per share in the transaction that resulted in such transfer to the
Trust (or, in the case of a devise or gift, the Market Price at the time of such
devise or gift) and (ii) the Market Price on the date the Company, or its
designee, accepts such offer. The Company shall have the right to accept such
offer until the Trustee has sold shares held in the Trust. Upon such a sale to
the Company, the interest of the Charitable Beneficiary in the shares sold shall
terminate and the Trustee shall distribute the net proceeds of the sale to the
intended transferee.
All certificates representing shares of Capital Stock will bear a legend
referring to the restrictions described above.
Every owner of more than five percent (or such lower percentage as required
by the Code or the regulations promulgated thereunder) of all classes or series
of the Company's stock, within 30 days after the end of each taxable year, is
required to give written notice to the Company stating the name and address of
such owner, the number of shares of each class and series of stock of the
Company beneficially owned and a description of the manner in which such shares
are held. Each such owner shall provide to the Company such additional
information as the Company may request in order to determine the effect, if any,
of such beneficial ownership on the Company's status as a REIT and to ensure
compliance with the ownership limitations.
Subject to certain limitations, the Board of Directors may increase or
decrease the ownership limitations. In addition, to the extent consistent with
the REIT provisions of the Code, the Board of Directors may waive
90
<PAGE> 95
the ownership limitations for and at the request of certain purchasers in this
Offering or subsequent purchasers.
The provisions described above may inhibit market activity and the
resulting opportunity for the holders of the Company's Capital Stock and
Warrants to receive a premium for their shares or Warrants that might otherwise
exist in the absence of such provisions. Such provisions also may make the
Company an unsuitable investment vehicle for any person seeking to obtain
ownership of more than 9.8% of the outstanding shares of Capital Stock.
LIMITATION OF LIABILITY AND INDEMNIFICATION
The Maryland GCL permits the charter of a Maryland corporation to include a
provision limiting the liability of its directors and officers to the
corporation and its stockholder for money damages, except to the extent that (i)
it is proved that the person actually received an improper benefit or profit in
money, property or services, or (ii) a judgment or other final adjudication
adverse to the person is entered in a proceeding based on a finding that the
person's action, or failure to act, was the result of active and deliberate
dishonesty and was material to the cause of action adjudicated in the
proceeding. The Company's Amended and Restated Articles of Incorporation contain
such a provision, which eliminates the liability of a director or officer to the
Company or its stockholders for money damages to the fullest extent permitted by
Maryland law.
Additionally, the Company's Amended and Restated Articles of Incorporation
provide for indemnification of its officers and directors to the fullest extent
permitted by the Maryland General Corporation Law (the "Maryland GCL"). The
Maryland GCL also permits the Company to indemnify and advance expenses to any
person who served a predecessor of the Company in any of the capacities
described above and to any employee or agent of the Company or a predecessor of
the Company.
Unless the corporation's charter provides otherwise, the Maryland GCL
requires a corporation to indemnify a director or officer who has been
successful, on the merits or otherwise, in the defense of any proceeding to
which he is made a party by reason of his service in that capacity. The Maryland
GCL permits a corporation to indemnify its present and former directors and
officers, among others, against judgments, penalties, fines, settlements and
reasonable expenses actually incurred by them in connection with any proceeding
to which they may be made a party by reason their service in those or other
capacities unless it is established that (a) the act or omission of the director
or officer was material to the matter giving rise to the proceeding and (1) was
committed in bad faith or (2) was the result of active and deliberate
dishonesty, (b) the director or officer actually received an improper personal
benefit in money, property or services or (c) in the case of any criminal
proceeding, the director or officer had reasonable cause to believe that the act
or omission was unlawful. However, a Maryland corporation may not indemnify for
an adverse judgment in a suit by or in the right of the corporation. In
addition, the Maryland GCL requires the Company, as a condition to advancing
expenses, to obtain (a) a written affirmation by the director or officer of his
good faith belief that he has met the standard of conduct necessary for
indemnification by the Company as authorized by the bylaws and (b) a written
undertaking by or on his behalf to repay the amount paid or reimbursed by the
Company if it shall ultimately be determined that the standard of conduct was
not met. A corporation may not indemnify a director unless the proposed
indemnification has been authorized for a specific proceeding pursuant to a
determination by the board of directors, special counsel (as may be appointed
for such purpose) or the stockholders that indemnification is permissible
because the director satisfied the requisite standard of conduct. Unless
otherwise provided by a corporation's charter, bylaws or board resolution
consistent with law, a corporation may not indemnify an officer or any other
person unless the proposed indemnification has been authorized for a specific
proceeding pursuant to a determination by the board of directors, special
counsel (as may be appointed for such purpose) or the stockholders that
indemnification is permissible because the officer or such other person
satisfied the requisite standard of conduct. The Company expects to enter into
indemnification agreements with its officers and directors which will provide
for the indemnification of such officers and directors to the fullest extent
permitted under Maryland law.
Insofar as indemnification for liabilities arising under the Securities Act
of 1933 may be permitted to directors, officers or persons controlling the
registrant pursuant to the foregoing provisions, the registrant has
91
<PAGE> 96
been informed that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Act and is
therefore unenforceable.
CONTROL SHARE ACQUISITIONS
The Maryland GCL provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition"have no voting rights except to the
extent approved by a vote of two-thirds of the votes entitled to be cast on the
matter, excluding shares of stock owned by the acquiror or by officers or
directors who are employees of the corporation. "Control shares" are voting
shares of stock which, if aggregated with all other shares of stock owned by
such a person, would entitle the acquiror to exercise voting power in electing
directors within one of the following ranges of voting power: (i) one-fifth or
more but less than one third, (ii) one-third or more but less than a majority,
or (iii) a majority or more of all voting power. "Control shares" do not include
shares of stock the acquiring person is then entitled to vote as a result of
having owned stockholder approval. A "control share acquisition" means, subject
to certain exceptions, the acquisition of, ownership of, or the power to direct
the exercise of voting power with respect to, control shares.
A person who has made or proposes to make a "control share acquisition,"
upon satisfaction of certain conditions (including an undertaking to pay
expenses), may compel the Board of Directors to call a special meeting of
stockholders to be held within 50 days of demand to consider the voting rights
of the shares. If no request for a meeting is made, the corporation may itself
present the question at any stockholders' meeting. If voting rights are not
approved at the meeting or if the acquiring person does not deliver an acquiring
person statement as permitted by the statute, then, subject to certain
conditions and limitations, the corporation may redeem any or all of the
"control shares" (except those for which voting rights have previously been
approved) for fair value determined, without regard to absence of voting rights,
as of the date of the last control share acquisition or of any meeting of
stockholders at which the voting rights of such shares are considered and not
approved. If voting rights for "control shares" are approved at a stockholders
meeting and the acquiror becomes entitled to vote a majority of the shares
entitled to vote, all other stockholders may exercise appraisal rights. The fair
value of the stock, as determined for purposes of such appraisal rights, may not
be less than the highest price per share paid in the control share acquisition,
and certain limitations and restrictions otherwise applicable to the exercise of
dissenters rights do not apply in the context of "control share acquisitions."
The "control share acquisition" statute does not apply to stock acquired in
a merger, consolidation or share exchange if the corporation is a party to the
transaction, or to acquisitions approved or exempted by a provision of the
articles of incorporation or bylaws of the corporation adopted prior to the
acquisition of the shares. The Company has adopted a provision in its Bylaws
that exempts the Company's shares of Capital Stock from application of the
control share acquisition statute. No assurance can be given, however, that such
Bylaw provision may not be removed at any time by amendment of the Bylaws.
BUSINESS ACQUISITIONS STATUTES
Under the Maryland GCL, certain "business combinations" (including a
merger, consolidation, share exchange, or, in certain circumstances, an asset
transfer or issuance or reclassification of equity securities) between a
Maryland corporation and any person who beneficially owns ten percent or more of
the voting power of the corporations shares or an affiliate of the corporation
which, at any time within the two-year period prior to the date in question, was
the beneficial owner of 10% or more of the voting power of the then-outstanding
voting stock of the corporation (an "Interested Stockholder") or an affiliate
thereof are prohibited for five years after the most recent date on which the
Interested Stockholder became an Interested Stockholder. Thereafter, any such
business combination must be recommended by the board of directors of such
corporation and approved by the affirmative vote of at least (a) 80% of the
votes entitled to be cast by holders of outstanding voting shares of the
corporation and (b) two-thirds of the votes entitled to be cast by holders of
outstanding voting shares of the corporation other than shares held by the
Interested Stockholder with whom the business combination is to be effected,
unless, among other things, the corporation's stockholders receive a minimum
price (as defined in the Maryland GCL) for their shares and the consideration is
received in cash or in the same form as previously paid by the Interested
Stockholder for its shares. These provisions of Maryland law do not apply,
however, to business combinations that are approved or exempted by the board of
directors
92
<PAGE> 97
of the corporation prior to the time that the Interested Stockholder becomes an
Interested Stockholder. No assurance can be given that such provision will not
be amended or eliminated at any point in the future with respect to business
combinations not involving a purchaser of Units.
TRANSFER AGENT AND REGISTRAR
American Securities Transfer & Trust Incorporated will initially act as
transfer agent and registrar with respect to the Common Stock.
93
<PAGE> 98
SHARES ELIGIBLE FOR FUTURE SALE
GENERAL
Upon the closing of this Offering, the Company will have outstanding
6,295,807 shares of Common Stock (including 1,295,807 shares issued to the
Founders if the over-allotment option is exercised), 5,000,000 shares of Common
Stock reserved for the Warrants (5,750,000 shares if the over-allotment option
is exercised) and 150,000 shares of Common Stock (172,500 shares if the
over-allotment option is exercised) reserved for the Representative's Warrants.
The Units issued in this Offering will be freely tradable immediately after this
Offering, and the Warrants and Common Stock issued in this Offering will be
freely tradable six months after this Offering, in each case by persons other
than "affiliates" of the Company without restriction under the Securities Act,
subject to the limitations on ownership set forth in the charter. See
"Description of Securities." The Common Stock to be owned by the Founders
(collectively, the "Restricted Stock"), will be "restricted securities" within
the meaning of Rule 144 promulgated under the Securities Act ("Rule 144") and
may not be sold except pursuant to registration under the Securities Act or
pursuant to an exemption from registration, including exemptions contained in
Rule 144. As described below under "Registration Rights," the Company has
granted certain holders registration rights with respect to their Common Stock.
See "-- Registration Rights."
In general, under Rule 144 as currently in effect, if one year has elapsed
since the later of the date of acquisition of Restricted Stock from the Company
or any "affiliate" of the Company, as that term is defined under the Securities
Act, the acquirer or subsequent holder thereof is entitled to sell within any
three-month period a number of shares of Common Stock that does not exceed the
greater of one percent of the then outstanding Common Stock or the average
weekly trading volume of the Common Stock during the four calendar weeks
preceding the date on which notice of the sale is filed with the Commission.
Sales under Rule 144 are also subject to certain manner of sale provisions,
public information requirements and notice requirements. After one year has
elapsed since the date of acquisition of Restricted Stock from the Company or
from any "affiliate" of the Company, and the acquirer or subsequent holder
thereof is deemed not to have been an "affiliate" of the Company at any time
during the 90 days preceding a sale, such person would be entitled to sell such
shares in the public market under Rule 144(k) without regard to the volume
limitation, manner of sale, public information or notice requirements.
Prior to the date of this Prospectus, there has been no public market for
the Units. Trading of the Units on the American Stock Exchange is expected to
commence effective upon the closing of this Offering. Sales of substantial
amounts of Common Stock or Warrants (including shares issued upon the exercise
of Stock Options), or the perception that such sales occur, could adversely
affect prevailing market prices of the Units, the Common Stock and Warrants. See
"Risk Factors -- Risks Associated with the Company's Combined Operations and
this Offering -- Absence of a Public Trading Market; Shares Eligible for Future
Sale; Fluctuations in Market Price."
The Company has reserved for issuance an aggregate of 37,526 shares of
Common Stock to be issued upon exercise of the Stock Options granted under the
1996 Stock Option Plan. All of such options have vested and are immediately
exercisable. The Company has reserved for issuance an aggregate of 456,667
shares of Common Stock to be issued pursuant to the exercise of Stock Options to
be granted under the 1998 Stock Option Plan. All Stock Options granted pursuant
to the 1998 Stock Option Plan will be contingent, with vesting based upon the
financial performance of the Company and such other criteria as the Compensation
Committee determines to be appropriate. See "Management -- Executive
Compensation -- 1998 Stock Option Plan."
For a description of certain restrictions on transfers of Common Stock held
by the Founders, see "Underwriting."
REGISTRATION RIGHTS
Pursuant to a registration rights agreement, the Company has granted the
Founders (except for ContiFinancial Corporation) certain additional registration
rights. Under such agreement, the Founders may
94
<PAGE> 99
request, on any two occasions on or after one year after the closing of the
Offering, that the Company file a shelf registration on Form S-3 with respect to
the number of registrable shares requested by the Founders, with the Company
paying all registration expenses in connection with the first such shelf
registration and the Founders paying all registration expenses for the second
such shelf registration. In addition, in the event the Company proposes to
register any of its Securities under the Securities Act, whether for its own
account or otherwise, the Founders are entitled to notice of such registration
and are entitled to include their registrable shares, subject to certain
conditions and limitations.
Pursuant to a registration rights agreement, the Company has granted
ContiFinancial Corporation certain registration rights. Under such agreement,
ContiFinancial Corporation may request, on any three occasions after an initial
public offering of the Company, that the Company register such shares as
ContiFinancial Corporation may request, provided that such shares amount to at
least five percent of the Company's Common Stock then outstanding and that such
request comes at least one year after the effective date of a registration
statement filed by the Company covering a firm commitment underwritten public
offering in which ContiFinancial Corporation shall have been entitled to join.
In addition, in the event the Company proposes to register any of its Securities
under the Securities Act, whether for its own account or otherwise,
ContiFinancial Corporation shall be entitled to notice of such registration
shall be entitled to include their registrable shares, subject to certain
conditions and limitations.
95
<PAGE> 100
FEDERAL INCOME TAX CONSIDERATIONS
THE FOLLOWING DISCUSSION SUMMARIZES THE MATERIAL FEDERAL INCOME TAX
CONSIDERATIONS THAT MAY BE RELEVANT TO A PROSPECTIVE PURCHASER OF UNITS. THIS
DISCUSSION IS BASED ON CURRENT LAW. THE FOLLOWING DISCUSSION IS NOT EXHAUSTIVE
OF ALL POSSIBLE TAX CONSIDERATIONS. IT DOES NOT GIVE A DETAILED DISCUSSION OF
ANY STATE, LOCAL OR FOREIGN TAX CONSIDERATIONS, NOR DOES IT DISCUSS ALL OF THE
ASPECTS OF FEDERAL INCOME TAXATION THAT MAY BE RELEVANT TO A PROSPECTIVE
INVESTOR IN LIGHT OF SUCH INVESTOR'S PARTICULAR CIRCUMSTANCES OR TO CERTAIN
TYPES OF INVESTORS (INCLUDING INSURANCE COMPANIES, CERTAIN TAX-EXEMPT ENTITIES,
FINANCIAL INSTITUTIONS, BROKER/DEALERS, FOREIGN CORPORATIONS AND PERSONS WHO ARE
NOT CITIZENS OR RESIDENTS OF THE UNITED STATES) SUBJECT TO SPECIAL TREATMENT
UNDER FEDERAL INCOME TAX LAWS.
EACH PROSPECTIVE PURCHASER OF UNITS IS ADVISED TO CONSULT WITH HIS OR HER
OWN TAX ADVISOR REGARDING THE SPECIFIC CONSEQUENCES TO HIM OR HER OF THE
PURCHASE, OWNERSHIP AND SALE OF UNITS, INCLUDING THE FEDERAL, STATE, LOCAL,
FOREIGN AND OTHER TAX CONSIDERATIONS OF SUCH PURCHASE, OWNERSHIP AND SALE AND
THE POTENTIAL CHANGES IN APPLICABLE TAX LAWS.
GENERAL
The Code provides special tax treatment for organizations that qualify and
elect to be taxed as REITs. The discussion below summarizes the material
provisions applicable to the Company as a REIT for federal income tax purposes
and to its stockholders in connection with their ownership of shares of stock of
the Company. However, it is impractical to set forth in this Prospectus all
aspects of federal, state, local and foreign tax law that may have tax
consequences with respect to an investor's purchase of Units. The discussion of
various aspects of federal taxation contained herein is based on the Code,
administrative regulations, judicial decisions, administrative rulings and
practice, all of which are subject to change. In brief, if certain detailed
conditions imposed by the Code are met, entities that invest primarily in real
estate assets, including Mortgage Loans, and that otherwise would be taxed as
corporations, with certain limited exceptions, are not taxed at the corporate
level on their taxable income that is currently distributed to their
stockholders. This treatment eliminates most of the "double taxation" (at the
corporate level and then again at the stockholder level when the income is
distributed) that typically results from the use of corporate investment
vehicles. A qualifying REIT, however, may be subject to certain excise and other
taxes, as well as normal corporate tax, on Taxable Income that is not currently
distributed to its stockholders. See "-- Taxation of the Company."
The Company intends to elect to be taxed as a REIT under the Code
commencing with its taxable year ending December 31, 1998.
OPINION OF COUNSEL
Jeffers, Wilson, Shaff & Falk, LLP, counsel to the Company ("Counsel"), has
advised the Company in connection with this Offering of Units and the Company's
election to be taxed as a REIT. Based on existing law and certain
representations made to Counsel by the Company and assuming that the Company
operates in the manner described in this Prospectus, in the opinion of Counsel,
commencing with the Company's taxable year ending December 31, 1998, RealTrust
has been organized in conformity with the requirements for qualification as a
REIT under the Code and the Company's proposed method of operation described in
this Prospectus and as represented by the Company to Counsel will enable
RealTrust to qualify as a REIT. However, whether RealTrust will in fact so
qualify will depend on actual operating results and compliance with the various
tests for qualification as a REIT relating to its income, assets, distributions,
ownership and certain administrative matters, the results of which may not be
reviewed by Counsel. Moreover, certain aspects of RealTrust's method of
operations have not been considered by the courts or the Service. There can be
no assurance that the courts or the Service will agree with this opinion. In
addition, qualification as a REIT
96
<PAGE> 101
depends on future transactions and events that cannot be known at this time.
Accordingly, Counsel is unable to opine whether RealTrust will in fact qualify
as a REIT under the Code in all events. In the opinion of Counsel, the section
of the Prospectus entitled "Federal Income Tax Considerations" identifies and
fairly summarizes the federal income tax considerations that are likely to be
material to a holder of the Units and to the extent such summaries involve
matters of law, such statements of law are correct under the Code. Counsel's
opinions are based on various assumptions and on the factual representations of
RealTrust concerning its business and assets. Accordingly, no assurance can be
given that the actual results of RealTrust's operation for any one taxable year
will satisfy such requirements. See "-- Termination or Revocation of REIT
Status."
The opinions of Counsel are based upon existing law including the Internal
Revenue Code of 1986, as amended, existing Treasury Regulations, Revenue
Rulings, Revenue Procedures, proposed regulations and case law, all of which is
subject to change either prospectively or retroactively. Moreover, relevant laws
or other legal authorities may change in a manner that could adversely affect
RealTrust or its stockholders.
In the event that RealTrust does not qualify as a REIT in any year, it will
be subject to federal income tax as a domestic corporation and its stockholders
will be taxed in the same manner as stockholders of ordinary corporations. To
the extent that RealTrust would, as a consequence, be subject to potentially
significant tax liabilities, the amount of earnings and cash available for
distribution to its stockholders would be reduced. See "-- Termination or
Revocation of REIT Status."
QUALIFICATION AS A REIT
To qualify for tax treatment as a REIT under the Code, the Company must
meet certain tests which are described immediately below.
OWNERSHIP OF STOCK
The Company's shares of stock must be transferable and, for all taxable
years after the first taxable year for which a REIT election is made, must be
held by a minimum of 100 persons for at least 335 days of a 12 month year (or a
proportionate part of a short tax year), and at all times during the second half
of each taxable year, no more than 50% in value of the shares of any class of
the stock of the Company may be owned directly or indirectly by five or fewer
individuals. In determining whether the Company's shares are held by five or
fewer individuals, the attribution rules of Section 544 of the Code (as modified
by the REIT provisions of the Code) apply. For a description of these
attribution rules, see "Description of Capital Stock." Failure of the Company to
comply with such test may be waived if the failure was unintentional and the
Company otherwise complied with the requirements for monitoring stockholders.
See "-- Recordkeeping Requirement." The Company's Amended and Restated Articles
of Incorporation impose certain transfer restrictions to avoid more than 50% by
value of any class of the Company's stock being held by five or fewer
individuals (directly or constructively) at any time during the last half of any
taxable year. Such transfer restrictions will not cause the stock not to be
treated as "transferable" for purposes of qualification as a REIT. The Company
intends to satisfy both the 100 stockholder and 50%/5 stockholder individual
ownership limitations described above for as long as it seeks qualification as a
REIT. See "Description of Capital Stock." Even if the Company were to
inadvertently violate one of the stock ownership tests, the Company would not
lose its status as a REIT for tax purposes provided the Company exercised
reasonable diligence in attempting to comply with these requirements. The
Company uses the calendar year as its taxable year for income tax purposes.
NATURE OF ASSETS
On the last day of each calendar quarter at least 75% of the value of the
Company's assets must consist of Qualified REIT Assets, government securities,
cash and cash items (the "75% of assets test"). The Company expects that
substantially all of its assets, other than the preferred stock of the Company's
Taxable Subsidiary, will be "Qualified REIT Assets" or "Qualified Hedges."
Qualified REIT Assets include interests in real property, interests in Mortgage
Loans secured by real property and interests in REMICs. Qualified Hedges are
discussed under "-- Sources of Income -- The 95% Test" below.
97
<PAGE> 102
On the last day of each calendar quarter, of the investments in securities
not included in the 75% of assets test, the value of any one issuer's equity and
debt securities may not exceed five percent by value of the Company's total
assets and the Company may not own more than 10% of any one issuer's outstanding
voting securities. See "Business -- Industry Developments." Pursuant to its
compliance guidelines, the Company intends to monitor closely (on not less than
a quarterly basis) the purchase and holding of the Company's assets in order to
comply with the above assets tests. In particular, as of the end of each
calendar quarter the Company intends to limit and diversify its ownership of
securities of any Taxable Subsidiary of the Company, hedging contracts and other
mortgage securities that do not constitute Qualified REIT Assets to less than
25%, in the aggregate, by value of its portfolio, to less than five percent by
value as to any single issuer, including the stock of any Taxable Subsidiary of
the Company, and to less than 10% of the voting stock of any single issuer
(collectively the "25% of assets limits"). If such limits are ever exceeded, the
Company intends to take appropriate remedial action to dispose of such excess
assets within the 30 day period after the end of the calendar quarter, as
permitted under the Code. In order to help maintain compliance with the
requirement that it limit the value of the securities of any issuer to less than
five percent of the value of the Company's assets, the Company expects to obtain
an appraisal report from a qualified independent business appraiser, to ensure
that the value of the assets contributed to the Taxable Subsidiary is less than
five percent of the gross value of the Company's assets.
When purchasing mortgage-related securities, the Company may rely on
opinions of counsel for the issuer or sponsor of such securities given in
connection with the offering of such securities, or statements made in related
offering documents, for purposes of determining whether and to what extent those
securities (and the income therefrom) constitute Qualified REIT Assets (and
income) for purposes of the 75% of assets test (and the source of income tests
discussed below). If the Company invests in a partnership, the Company will be
treated as receiving its share of the income and loss of the partnership and
owning a proportionate share of the assets of the partnership and any income
from the partnership will retain the character that it had in the hands of the
partnership.
SOURCES OF INCOME
The Company must meet two separate income-based tests for each year in
order to qualify as a REIT.
1. The 75% Test. At least 75% of the Company's gross income (the "75% of
income test") for the taxable year must be derived from the following sources
among others: (i) interest (other than interest based in whole or in part on the
income or profits of any person) on obligations secured by mortgages on real
property or on interests in real property, (ii) gains from the sale or other
disposition of interests in real property and real estate mortgages, other than
gain from property held primarily for sale to customers in the ordinary course
of the Company's business ("dealer property"), (iii) income from the operation,
and gain from the sale, of property acquired at or in lieu of a foreclosure of
the mortgage secured by such property or as a result of a default under a lease
of such property ("foreclosure property"), (iv) income received as consideration
for entering into agreements to make loans secured by real property or to
purchase or lease real property (including interests in real property and
interests in mortgages on real property) (for example, commitment fees), (v)
rents from real property, and (vi) income attributable to stock or debt
instruments acquired with the proceeds from the sale of stock or certain debt
obligations ("new capital") of the Company received during the one-year period
beginning on the day such proceeds were received ("qualified temporary
investment income"). The investments that the Company intends to make (as
described under "Business -- Mortgage Investment Portfolio") will give rise
primarily to mortgage interest qualifying under the 75% of income test.
2. The 95% Test. In addition to deriving 75% of its gross income from the
sources listed above, at least an additional 20% of the Company's gross income
for the taxable year must be derived from those sources, or from dividends,
interest or gains from the sale or disposition of stock or other securities that
are not dealer property (the "95% of income test"). Income attributable to
assets other than Qualified REIT Assets, such as income from or gain on the
disposition of Qualified Hedges, that the Company holds, dividends on non-REIT
stock (including any dividends from the Taxable Subsidiary), interest on any
other obligations not secured by real property, and gains from the sale or
disposition of stock or other securities that are not Qualified REIT
98
<PAGE> 103
Assets or Qualified Hedges will constitute qualified income for purposes of the
95% of income test only, and will not be qualified income for purposes of the
75% of income test. Income from mortgage servicing, loan guarantee fees (or
other contracts under which the Company would earn fees for performing services)
and hedging (other than from Qualified REIT Assets) will not qualify for either
the 95% or 75% of income tests. Income from Qualified Hedges (including gain on
the sale of Qualified Hedges) qualifies for the 95% of income test. The Code
defines a Qualified Hedge as a swap, cap or similar financial instrument entered
into by a REIT to reduce interest rate risks with respect to debt that the REIT
incurred to acquire or carry real estate assets, such as Mortgage Loans. The
Company intends to severely limit its acquisition of any assets or investments
the income from which does not qualify for purposes of the 95% of income test.
Moreover, in order to help ensure compliance with the 95% of income test and the
75% of income test, the Company intends to limit substantially all of the assets
that it acquires (other than the shares of the preferred stock of any Taxable
Subsidiary and Qualified Hedges) to Qualified REIT Assets. The policy of the
Company to maintain REIT status may limit the type of assets, including hedging
contracts, that the Company otherwise might acquire.
For purposes of determining whether the Company complies with the 75% of
income test and the 95% of income test detailed above, gross income does not
include gross income from "prohibited transactions." A "prohibited transaction"
is one involving a sale of dealer property, other than foreclosure property. Net
income from "prohibited transactions" is subject to a 100% tax. See "-- Taxation
of the Company."
The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions, futures contracts and sales
of Mortgage Assets to comply with the 75% of income test and the 95% of income
test. See "-- Taxation of the Company" for a discussion of the potential tax
cost of the Company's selling certain Mortgage Assets on a regular basis. In
order to help insure its compliance with the REIT requirements of the Code, the
Company has adopted guidelines the effect of which will be to limit the
Company's ability to earn certain types of income, including income from
hedging, other than hedging income from Qualified REIT Assets and from Qualified
Hedges. See "Business -- Interest Rate Risk Management."
If the Company fails to satisfy one or both of the 75% or 95% of income
tests for any year, it may face either (a) assuming such failure was for
reasonable cause and not willful neglect, and a schedule is submitted to the
Service setting forth the nature and amount of each item of the Company's gross
income qualifying under the 75% or 95% income tests, a 100% tax on the greater
of the amounts of income by which it failed to comply with the 75% test of
income or the 95% of income test, reduced by estimated related expenses or (b)
loss of REIT status. There can be no assurance that the Company will always be
able to maintain compliance with the gross income tests for REIT qualification
despite the Company's periodic monitoring procedures. Moreover, there is no
assurance that the relief provisions for a failure to satisfy either the 95% or
the 75% of income tests will be available in any particular circumstance.
DISTRIBUTIONS
The Company must distribute to its stockholders on a pro rata basis each
year an amount equal to (i) 95% of its Taxable Income before deduction of
dividends paid and excluding net capital gain, plus (ii) 95% of the excess of
the net income from foreclosure property over the tax imposed on such income by
the Code, less (iii) any "excess noncash income' (the "95% distribution test").
See "Dividend Policy and Distributions." The Company intends to make
distributions to its stockholders in amounts sufficient to meet this 95%
distribution requirement. Such distributions must be made in the taxable year to
which they relate, or during January of the subsequent taxable year when
declared during the last quarter of such taxable year and payable to
shareholders of record on a specified date during such quarter, or, if declared
before the timely filing of the Company's tax return for such year and paid not
later than the first regular dividend payment after such declaration, in the
following taxable year. A nondeductible excise tax, equal to four percent of the
excess of such required distributions over the amounts actually distributed will
be imposed on the Company for each calendar year to the extent that the sum of
the dividends paid during the year (or declared during the last quarter of the
year and paid during January of the succeeding year) and any tax imposed on the
REIT taxable
99
<PAGE> 104
income or capital gains of the Company is less than the sum of (i) 85% of the
Company's "ordinary income," (ii) 95% of the Company's capital gain net income,
and (iii) income not distributed in earlier years.
If the Company fails to meet the 95% distribution test as a result of an
adjustment to the Company's tax returns by the Service, the Company by following
certain requirements set forth in the Code, may pay a deficiency dividend within
a specified period which will be permitted as a deduction in the taxable year to
which the adjustment is made. The Company would be liable for interest based on
the amount of the deficiency dividend. A deficiency dividend is not permitted if
the deficiency is due to fraud with intent to evade tax or to a willful failure
to file timely tax returns.
TAXATION OF THE COMPANY
In any year in which the Company qualifies as a REIT, it generally will not
be subject to federal income tax on that portion of its taxable income or net
capital gain which is distributed to its stockholders. The Company will,
however, be subject to tax at normal corporate rates upon any net income or net
capital gain not distributed. The Company intends to distribute substantially
all of its taxable income to its stockholders on a pro rata basis in each year.
See "Dividend Policy and Distributions." If the Company recognizes net income at
a time when its cash receipts from Mortgage Assets are subject to the claims of
creditors, such as counterparties on reverse repurchase agreements, the Company
may be compelled to borrow to distribute dividends and avoid the imposition of
corporate level tax.
In addition, the Company will also be subject to a tax of 100% of net
income from any prohibited transaction and will be subject to a 100% tax on the
greater of the amount by which it fails either the 75% or 95% of income tests,
reduced by approximated expenses, if the failure to satisfy such tests is due to
reasonable cause and not willful neglect and if certain other requirements are
met. The Company may be subject to the alternative minimum tax on certain items
of tax preference.
If the Company acquires any real property as a result of foreclosure, or by
a deed in lieu of foreclosure, the Company may elect to treat such real property
as "foreclosure property." Net income from the sale of foreclosure property is
taxable at the maximum federal corporate rate, currently 35%. Income from
foreclosure property will not be subject to the 100% tax on prohibited
transactions. The Company will determine whether to treat such real property as
foreclosure property on the tax return for the fiscal year in which such
property is acquired.
The Company will finance Mortgage Loans and sell such Mortgage Loans
through one or more Taxable Subsidiaries. However, if the Company itself were to
sell such Mortgage Assets on a regular basis, there is a substantial risk that
they would be deemed "dealer property" and that all of the profits from such
sales would be subject to tax at the rate of 100% as income from prohibited
transactions. The Taxable Subsidiary will not be subject to this 100% tax on
income from prohibited transactions, which is only applicable to REITs, rather,
it will be subject to tax on such income at regular corporate rates. See
"Business -- Industry Developments" for a discussion of the possible effect of a
recent proposal, if enacted, on such proposed activities of the Company.
The Company will also be subject to the nondeductible four percent excise
tax discussed above if it fails to make timely dividend distributions for each
calendar year. See "-- Qualification as a REIT -- Distributions." The Company
intends to declare its fourth regular annual dividend during the final quarter
of the year and to make such dividend distribution no later than thirty-one (31)
days after the end of the year in order to avoid imposition of the excise tax.
Such a distribution would be taxed to the stockholders in the year that the
distribution was declared, not in the year paid. Imposition of the excise tax on
the Company would reduce the amount of cash available for distribution to the
Company's stockholders.
TAXATION OF TAXABLE SUBSIDIARY
The Company may cause the creation and sale of Mortgage Assets or conduct
certain hedging activities through one or more Taxable Subsidiaries. The Company
and one or more persons or entities will own all of the capital stock of such
Taxable Subsidiary. In order to ensure that the Company will not violate the
100
<PAGE> 105
prohibition on ownership of more than 10% of the voting stock of a single issuer
and the prohibition on investing more than five percent of the value of its
assets in the stock or securities of a single issuer, the Company will own only
shares of nonvoting preferred stock of the Taxable Subsidiary and will not own
any of the Taxable Subsidiary's common stock. The Company will monitor the value
of its investment in the Taxable Subsidiary on a quarterly basis to limit the
risk of violating any of the tests that comprise the 25% of assets limits. In
addition, the dividends that the Taxable Subsidiary pays to the Company will not
qualify as income from Qualified REIT Assets for purposes of the 75% of income
test, and in all events would have to be limited, along with the Company's other
interest, dividends, gains on the sale of securities, hedging income, and other
income not derived from Qualified REIT Assets to less than 25 percent of the
Company's gross revenues in each year. Before the Company forms any such Taxable
Subsidiary, the Company intends to obtain an opinion of counsel to the effect
that the formation and contemplated operation of such a corporation will not
cause the Company to fail the REIT asset and income tests. See "Qualification as
a REIT -- Nature of Assets" and "Qualification as a REIT -- Sources of Income."
The Taxable Subsidiary will not elect REIT status, will be subject to income
taxation on its net earnings and will generally be able to distribute only its
net after-tax earnings to its stockholders, including the Company, as dividend
distributions. If the Taxable Subsidiary creates a taxable mortgage pool, such
pool itself will constitute a separate taxable subsidiary of the Taxable
Subsidiary. The Taxable Subsidiary would be unable to offset the income derived
from such a taxable mortgage pool with losses derived from any other activities.
TERMINATION OR REVOCATION OF REIT STATUS
The Company's election to be treated as a REIT will be terminated
automatically (i) if the Company fails to meet the requirements described above
or (ii) if the President's 1999 Budget Plan is adopted, as presently proposed.
See "Risk Factors." In that event, the Company will not be eligible again to
elect REIT status until the fifth taxable year which begins after the year for
which the Company's election was terminated unless all of the following relief
provisions apply: (i) the Company did not willfully fail to file a timely return
with respect to the termination taxable year, (ii) inclusion of incorrect
information in such return was not due to fraud with intent to evade tax, and
(iii) the Company establishes that failure to meet requirements was due to
reasonable cause and not willful neglect. The Company may also voluntarily
revoke its election, although it has no intention of doing so, in which event
the Company will be prohibited, without exception, from electing REIT status for
the year to which the revocation relates and the following four taxable years.
If the Company fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions do not apply, the Company would be subject to tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. Distributions to stockholders of the Company with
respect to any year in which the Company fails to qualify as a REIT would not be
deductible by the Company nor would they be required to be made. Failure to
qualify as a REIT would result in the Company's reduction of amounts available
for distribution to its stockholders in order to pay the resulting taxes. If,
after forfeiting REIT status, the Company later qualifies and elects to be taxed
as a REIT again, the Company could face significant adverse tax consequences.
TAXATION OF THE COMPANY'S STOCKHOLDERS
GENERAL
For any taxable year in which the Company is treated as a REIT for federal
income tax purposes, amounts distributed by the Company to its stockholders out
of current or accumulated earnings and profits will be includible by the
stockholders as ordinary income for federal income tax purposes unless properly
designated by the Company as capital gain dividends. In the latter case, the
distributions will be taxable to the stockholders as long-term capital gains.
Additionally, the Company may elect to retain and pay taxes on all or a
portion of its net long-term capital gains for any taxable year, in which case,
the stockholders would include in their income as long-term capital gains their
proportionate share of such undistributed capital gains. The stockholders would
be treated
101
<PAGE> 106
as having paid their proportionate share of any taxes paid by the Company on any
undistributed capital gains, which proportionate amounts would be credited or
refunded to the stockholders.
Distributions of the Company will not be eligible for the dividends
received deduction for corporations. Stockholders may not deduct any net
operating losses or capital losses of the Company.
Any loss on the sale or exchange of shares of the stock of the Company held
by a stockholder for six months or less will be treated as a long-term capital
loss to the extent of any capital gain dividend received, or undistributed
capital gains treated as received, on the stock held by such stockholders.
If the Company makes distributions to its stockholders in excess of its
current and accumulated earnings and profits, those distributions will be
considered first a tax-free return of capital, reducing the tax basis of a
stockholder's shares until the tax basis is zero. Such distributions in excess
of the tax basis will be taxable as gain realized from the sale of the Company's
shares.
The Company (exclusive of its Taxable Subsidiary) does not expect to
acquire or retain residual interests issued by REMICs. Such residual interests,
if acquired by a REIT, would generate excess inclusion income. Excess inclusion
income cannot be offset by net operating losses of a stockholder. If the
stockholder is a Tax-Exempt Entity, the excess inclusion income is fully taxable
as UBTI. If allocated to a foreign stockholder, the excess inclusion income is
subject to Federal income tax withholding without reduction pursuant to any
otherwise applicable tax treaty. Excess inclusion income realized by a Taxable
Subsidiary is not passed through to stockholders of the Company. Potential
investors, and in particular Tax Exempt Entities, are urged to consult with
their tax advisors concerning this issue.
The Company intends to finance the acquisition of Mortgage Assets by
entering into reverse repurchase agreements, which are essentially loans secured
by the Company's Mortgage Assets. The Company expects to enter into master
repurchase agreements with secured lenders known as "counterparties." Typically,
such master repurchase agreements have cross-collateralization provisions that
afford the counterparty the right to foreclose on the Mortgage Assets pledged as
collateral. If the Service were to successfully take the position that the
cross-collateralization provisions of the master repurchase agreements result in
the Company having issued debt instruments (the reverse repurchase agreements)
with differing maturity dates secured by a pool of Mortgage Loans, a portion of
the Company's income could be characterized as "excess inclusion income."
Counsel has advised the Company that it is more likely than not that the
cross-collateralization provisions of the master repurchase agreements will not
cause the Company to realize excess inclusion income. Nevertheless, in the
absence of any definitive authority on this issue, Counsel cannot give complete
assurance.
The Company will notify stockholders after the close of the Company's
taxable year as to the portions of the distributions which constitute ordinary
income, return of capital and capital gain. Dividends and distributions declared
in the last quarter of any year payable to stockholders of record on a specified
date in such month will be deemed to have been received by the stockholders and
paid by the Company on December 31 of the record year, provided that such
dividends are paid before February 1 of the following year.
WARRANTS
Upon the exercise of a Warrant, a holder will not recognize gain or loss
and will have a tax basis in the Common Stock received equal to the tax basis in
such holder's Warrant plus the exercise price thereof. The holding period for
the Common Stock purchased pursuant to the exercise of a Warrant will begin on
the day following the date of exercise and will not include the period that the
holder held the Warrant.
Upon a sale or other disposition of a Warrant, a holder will recognize
capital gain or loss in an amount equal to the difference between the amount
realized and the holder's tax basis in the Warrant. Such a gain or loss will be
long-term if the holding period is more than one year. In the event that a
Warrant lapses unexercised, a holder will recognize a capital loss in an amount
equal to his tax basis in the Warrant. Such loss will be long-term if the
Warrant has been held for more than one year.
102
<PAGE> 107
ADJUSTMENTS TO EXERCISE PRICE OF THE WARRANTS
Adjustments in the Exercise Price (or the failure to make such adjustments)
pursuant to the anti-dilution provisions of the Warrants or otherwise may result
in constructive distributions to the holder of Warrants that could, under
certain circumstances, be taxable to them as dividends pursuant to Section 305
of the Code. If such a constructive distribution were to occur, a holder of
Warrants could be required to recognize ordinary income for tax purposes without
receiving a corresponding distribution of cash.
TAXATION OF TAX-EXEMPT ENTITIES
In general, a Tax-Exempt Entity that is a stockholder of the Company is not
subject to tax on distributions. The Service has ruled that amounts distributed
by a REIT to an exempt employees' pension trust do not constitute UBTI and thus
should be nontaxable to such a Tax-Exempt Entity. Based on that ruling, but
subject to the discussion of excess inclusion income set forth under the heading
"Taxation of the Company's Stockholders," Counsel is of the opinion that
indebtedness incurred by the Company in connection with the acquisition of real
estate assets such as Mortgage Loans will not cause dividends of the Company
paid to a stockholder that is a Tax-Exempt Entity to be UBTI, provided that the
Tax-Exempt Entity has not financed the acquisition of its stock with
"acquisition indebtedness" within the meaning of the Code. Under certain
conditions, if a tax-exempt employee pension or profit sharing trust were to
acquire more than 10% of the Company's stock, a portion of the dividends on such
stock could be treated as UBTI.
For social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans exempt
from federal income taxation under Code Sections 501(c)(7), (c)(9), (c)(17) and
(c)(20), respectively, income from an investment in the Company, including gain
realized on the sale of such an investment, will constitute UBTI unless the
organization is able to properly deduct amounts set aside or placed in reserve
for certain purposes so as to offset the UBTI generated by its investment in the
Company. Such entities should review Code Section 512(a)(3) and should consult
their own tax advisors concerning these "set aside" and reserve requirements.
FOREIGN INVESTORS
The preceding discussion does not address the federal income tax
consequences to foreign investors (non-resident aliens and foreign corporations
as defined in the Code) of an investment in the Company. In general, foreign
investors will be subject to special withholding tax requirements on income and
capital gains distributions attributable to their ownership of the Company's
stock. Foreign investors in the Company should consult their own tax advisors
concerning the federal income tax consequences to them of a purchase of shares
of the Company's stock including the federal income tax treatment of
dispositions of interests in, and the receipt of distributions from, REITs by
foreign investors. In addition, federal income taxes must be withheld on certain
distributions by a REIT to foreign investors unless reduced or eliminated by an
income tax treaty between the United States and the foreign investor's country.
A foreign investor eligible for reduction or elimination of withholding must
file an appropriate form with the Company in order to claim such treatment.
RECORDKEEPING REQUIREMENT
A REIT is required to maintain records regarding the actual and
constructive ownership of its shares, and other information, and within 30 days
after the end of its taxable year, to demand statements from persons owning
above a specified level of the REIT's shares (e.g., if the Company has over 200
but fewer than 2,000 stockholders of record, from persons holding one percent or
more of the Company's outstanding shares of stock and if the Company has 200 or
fewer stockholders of record, from persons holding 1/2% or more of the stock)
regarding their ownership of shares. The Company must maintain, as part of the
Company's records, a list of those persons failing or refusing to comply with
this demand. Stockholders who fail or refuse to comply with the demand must
submit a statement with their tax returns setting forth their actual stock
ownership and other information. The Company intends to maintain the records and
demand statements as required by these regulations.
103
<PAGE> 108
BACKUP WITHHOLDING
The Code imposes a modified form of "backup withholding" for payments of
interest and dividends. This withholding applies only if a stockholder, among
other things, (i) fails to furnish the Company with a properly certified
taxpayer identification number, (ii) furnishes the Company with an incorrect
taxpayer identification number, (iii) fails properly to report interest or
dividends from any source, or (iv) under certain circumstances fails to provide
the Company or the stockholder's securities broker with a certified statements,
under penalty of perjury, that he or she is not subject to backup withholding.
The backup withholding rate is 31% of "reportable payments," which include
the Company's dividends. Stockholders should consult their tax advisors as to
the procedure for insuring that Company distributions to them will not be
subject to backup withholding.
The Company will report to its stockholders and the Service the amount of
dividends paid during each calendar year and the amount of tax withheld, if any.
RECENT LEGISLATIVE PROPOSALS
The President's 1999 Budget Plan, as presented to Congress on February 2,
1998, contains several provisions which affect REITs. One such provision, if
enacted, could have a potential adverse effect on the way that the Company
intends to operate its mortgage conduit operations. That provision would
prohibit the ownership by a REIT of more than 10% the stock of another
corporation, by vote or value. The rules currently in place for qualification as
a REIT limit (i) a REIT to owning less than 10% of the outstanding voting
securities of another corporation and (ii) the value of a REIT's ownership of
the securities of any one issuer to less than five percent of the value of the
REIT's assets. (See " -- Nature of Assets" above). By limiting a REIT's
ownership of the securities of another corporation to 10% of the value of the
issuing corporation, the proposal, if enacted, could cause the Company to have
to divest itself of most of the preferred stock of the Taxable Subsidiary that
the Company currently owns. In such an event the Company would not receive the
dividends that the Company expects to earn from the Taxable Subsidiary, which
could have a material adverse effect on the Company's net profits after such
divestiture. If that proposal is enacted in substantially the form proposed, the
Company would originate and acquire only those Mortgage Loans that it intends to
retain for investment. See "Business -- Industry Developments" for a more
detailed discussion of the budget proposal.
STATE AND LOCAL TAXES
State and local tax laws may not correspond to the federal income tax
principles discussed in this section. Accordingly, prospective stockholders
should consult their tax advisers concerning the state and local tax
consequences of an investment in the Company's stock.
ERISA CONSIDERATIONS
In considering an investment in the Common Stock of the Company, a
fiduciary of a profit-sharing, pension stock bonus plan, or individual
retirement account, including a plan for self-employed individuals and their
employees or any other employee benefit plan subject to prohibited transaction
provisions of the Code or the fiduciary responsibility provisions of ERISA (an
"ERISA Plan") should consider (a) whether the ownership of Common Stock is in
accordance with the documents and instruments governing such ERISA Plan, (b)
whether the ownership of Common Stock is consistent with the fiduciary's
responsibilities and satisfies the requirements of Part 4 of Subtitle B of Title
I of ERISA (where applicable) and, in particular, the diversification, prudence
and liquidity requirements of Section 404 of ERISA, (c) ERISA's prohibitions in
improper delegation of control over, or responsibility for, "plan assets" and
ERISA's imposition of co-fiduciary liability on a fiduciary who participates in,
permits (by action or inaction) the occurrence of, or fails to remedy a known
breach of duty by another fiduciary, and (d) the need to value the assets of the
ERISA Plan annually.
In regard to the "plan assets" issue noted in clause (c) above, Counsel is
of the opinion that, effective as of the date of the closing of this Offering
and the listing of the shares of Common Stock on the American
104
<PAGE> 109
Stock Exchange, and based on certain representations of the Company, the Common
Stock should qualify as a "publicly-offered security," and, therefore, the
acquisition of such Common Stock by ERISA Plans should not cause the Company's
assets to be treated as assets of such investing ERISA Plans for purposes of the
fiduciary responsibility provisions of ERISA or the prohibited transaction
provisions of the Code. Fiduciaries of ERISA Plans and IRA's should consult with
and rely upon their own advisors in evaluating the consequences under the
fiduciary provisions of ERISA and the Code of an investment in Common Stock in
light of their own circumstances.
105
<PAGE> 110
UNDERWRITING
Under the terms of and subject to the conditions contained in the
underwriting agreement (the "Underwriting Agreement") between the Company and
the Underwriters named below (the "Underwriters"), for whom Stifel, Nicolaus &
Company, Incorporated is acting as representative (the "Representative"), the
Underwriters have severally agreed to purchase from the Company and the Company
has agreed to sell to the Underwriters severally the respective number of Units
set forth opposite its name below:
<TABLE>
<CAPTION>
NUMBER OF UNITS
TO BE
UNDERWRITER PURCHASED
----------- ---------------
<S> <C>
Stifel, Nicolaus & Company, Incorporated....................
EVEREN Securities, Inc......................................
Total............................................. 5,000,000
=========
</TABLE>
In the Underwriting Agreement, the Underwriters have severally agreed,
subject to the terms and conditions set forth therein, to purchase all of the
Units being sold pursuant to the Underwriting Agreement (other than those
covered by the over-allotment option described below). In the event of a default
by any Underwriter, the Underwriting Agreement provides that, in certain
circumstances, the purchase commitments of the nondefaulting Underwriters may be
increased or the Underwriting Agreement may be terminated.
The Company has been advised by the Representative that the Underwriters
propose to offer the Units in part to the public at the Price to Public set
forth on the cover page of this Prospectus, and in part to certain securities
dealers (who may include Underwriters) at such price less a concession not in
excess of $ per Unit, and that the Underwriters and such dealers may reallow
to certain dealers, a discount not in excess of $ per Unit. After
commencement of the public offering, the Price to Public, concessions to
selected dealers and the discount to other dealers may be changed by the
Representatives.
The Company has granted an option to the Underwriters, exercisable during
the 30-day period after the date of this Prospectus, to purchase, at the Price
to Public less the underwriting discount set forth on the cover page of this
Prospectus, up to 750,000 additional Units. The Underwriters may exercise such
option only to cover over-allotments, if any, made in connection with the
Offering of the Units offered hereby. To the extent the Underwriters exercise
such option, each of the Underwriters will become obligated, subject to certain
conditions, to purchase approximately the same percentage of such option Units
as it was obligated to purchase pursuant to the Underwriting Agreement.
The Company and certain of its affiliates have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Federal securities laws, or to contribute to payments which the Underwriters may
be required to make in respect thereof.
The Company and the Founders have agreed with the Underwriters that, for a
period of one year following the closing of this Offering, they will not offer,
sell, contract to sell or otherwise dispose of any shares of Common Stock or
rights to acquire such shares without the prior written consent of the
Representatives. See "Shares Eligible For Future Sale."
The Company has agreed to grant to the Representative warrants to purchase
150,000 (172,500 if the over-allotment option is exercised) shares of Common
Stock at an exercise price equal to the Price to Public
106
<PAGE> 111
of the Units (the "Representative's Warrants"). The Representative's Warrants
are exercisable for a period of three years beginning six months after the
initial closing of this Offering. The Representative's Warrants and, if
exercised, the underlying securities, may not be sold, transferred, assigned,
pledged or hypothecated for a period of one year following the date of this
Prospectus except to any officer or partner of a Representative or by operation
of law. The Representative's Warrants contain anti-dilution provisions providing
for appropriate adjustment upon the occurrence of certain events. See
"Description of Securities."
The Representative and EVEREN Securities, Inc. (the "Lead Underwriters")
have informed the Company that it does not expect the Underwriters to confirm
sales of Units offered by this Prospectus to any accounts over which they
exercise discretionary authority.
The Company intends to apply for listing of the Units, the Warrants and the
Common Stock on the American Stock Exchange. See "Summary -- The Offering."
Prior to the closing of this Offering, there has been no public market for
the Units. Accordingly, the Price to Public for the Units has been determined by
negotiations between the Company and the Representatives. Among the factors
which were considered in determining the Price to Public were the Company's
future prospects, the experience of its management, the economic condition of
the financial services industry in general, the general condition of the equity
securities market, the demand for similar securities of companies considered
comparable to the Company and other relevant factors.
The Price to Public set forth on the cover page of this Prospectus should
not be considered an indication of the actual value of the Units. Such price is
subject to change as a result of market conditions and other factors and no
assurance can be given that the Units can be resold at the Price to Public of
the Units after the closing of this Offering.
Until the distribution of the Units is completed, rules of the Commission
may limit the ability of the Underwriters and certain selling group members to
bid for and purchase the Units. As an exception to these rules, the Lead
Underwriters are permitted to engage in certain transactions that stabilize the
prices of the Units. Such transactions consist of bids or purchases for the
purpose of pegging, fixing or maintaining the price of such securities. If the
Underwriters create a short position in the Units in connection with this
Offering, i.e., if they sell a greater number of Units than is set forth in the
cover page of this Prospectus, then the Lead Underwriters may reduce that short
position by purchasing Units in the open market. The Lead Underwriters may also
elect to reduce any short position by exercising all or part of the
over-allotment option described herein. The Lead Underwriters may also impose a
penalty bid on certain Underwriters and selling group members. This means that
if the Lead Underwriters purchase Units in the open market to reduce the
Underwriters' short position or to stabilize the price of the Units, it may
reclaim the amount of the selling concession from the Underwriters and selling
group members who sold those securities as part of the Offering. In general,
purchases of a security for the purpose of stabilization or to reduce a short
position could cause the price of the security to be higher than it might be in
the absence of such purchases. The imposition of a penalty bid might also have
an effect on the price of a security to the extent that it were to discourage
resales of the security. These transactions may be effected on the American
Stock Exchange or otherwise. Neither the Company nor any of the Underwriters
makes any representation or prediction as to the direction or magnitude of any
effect that the transactions described above may have on the prices of the
Units. In addition, neither the Company nor any of the Underwriters makes any
representation that the Representatives will engage in such transactions, or
that such transactions, once commenced, will not be discontinued without notice.
LEGAL MATTERS
The validity of the Securities offered hereby and certain tax matters will
be passed on by Jeffers, Wilson, Shaff & Falk, LLP, Irvine, California.
Christopher A. Wilson, Esq. and Michael E. Shaff, Esq., partners of Jeffers,
Wilson, Shaff & Falk, LLP, have been granted options to purchase 2,700 and 1,080
shares of Common Stock, respectively. Certain legal matters will be passed upon
for the Underwriters by O'Melveny & Myers LLP, San Francisco, California.
107
<PAGE> 112
EXPERTS
The financial statements of CMG Funding Corp. (formerly Continental
Mortgage Group, LC) as of December 31, 1997 and 1996, and for the year ended
December 31, 1997 and the period from February 7, 1996 (date of inception) to
December 31, 1996, have been included herein and in the registration statement
in reliance upon the report of KPMG Peat Marwick LLP, independent certified
public accountants appearing elsewhere herein, and upon the authority of said
firm as experts in accounting and auditing.
ADDITIONAL INFORMATION
The Company has filed with the Commission, Washington, D.C. 20549, a
Registration Statement (the "Registration Statement") under the Securities Act
of 1933, as amended (the "Securities Act"), with respect to the Units offered
hereby. Copies of the Registration Statement and the exhibits thereto are on
file at the offices of the Commission in Washington, D.C. and may be obtained at
rates prescribed by the Commission upon request to the Commission and inspected,
without charge, at the offices of the Commission. Prior to the Offering, the
Company has not been required to file reports under the Exchange Act. However,
following the closing of this Offering, the Company will be required to file
reports and other information with the Commission pursuant to the Exchange Act.
Such reports and other information can be inspected and copied at the public
reference facilities maintained by the Commission at 450 Fifth Street, N.W.,
Washington, D.C. 20549, and at the Commission's regional offices at Northwestern
Atrium Center, 500 West Madison Street (Suite 1400), Chicago, Illinois 60661 and
7 World Trade Center, New York, New York 10048. Copies of such material can also
be obtained from the Commission at prescribed rates through its Public Reference
Section at 450 Fifth Street, N.W., Washington, D.C. 20549. The Commission
maintains a Web site that contains reports, proxy, information statements and
other information regarding registrants that file electronically with the
Commission. The Web site is located at http://www.sec.gov. Statements contained
in this Prospectus as to the contents of any contract or any contract or other
document referred to are not necessarily complete, and in each instance
reference is made to the copy of such contract or other document filed as an
exhibit to the Registration Statement, each such statement being qualified in
all respect by such reference.
108
<PAGE> 113
GLOSSARY
As used in this Prospectus, the capitalized and other terms listed below
have the meanings indicated.
"Affiliated Person" means of any entity: (i) any person directly or
indirectly owning, controlling, or holding with the power to vote, five percent
or more of the outstanding securities of such entity; (ii) any person five
percent or more of whose outstanding voting securities are directly or
indirectly owned, controlled, or held with power to vote, by such entity; (iii)
any person directly or indirectly controlling, controlled by, or under common
control with, such entity; or (iv) any officer, director or employee of such
entity or any person set forth in (i), (ii) or (iii) above. Any person who owns
beneficially, either directly or through one or more controlled companies, more
than twenty-five percent (25%) of the voting securities of any entity shall be
presumed to control such entity. Any person who does not so own more than
twenty-five percent (25%) of the voting securities of any entity shall be
presumed not to control such entity. A natural person shall be presumed not to
be a controlled entity.
"Agency" means FNMA, FHLMC or GNMA.
"Agency Certificates" means pass-through certificates guaranteed by FNMA,
FHLMC or GNMA.
"ARM" means a Mortgage Loan (including any Mortgage Loan underlying a
Mortgage Security) that features adjustments of the underlying interest rate at
predetermined times based on an agreed margin to an established index. An ARM is
usually subject to periodic interest rate and/or payment caps and a lifetime
interest rate cap.
"Beneficial Owner" means any actual purchaser of a Warrant.
"CAG" means Capital Allocation Guidelines.
"Capital Stock" means the shares of capital stock issuable by the Company
under its Amended and Restated Articles of Incorporation, and includes Common
Stock and preferred stock.
"Capstone" means Capstone Investments, Inc., a Nevada corporation.
"Charitable Beneficiary" means one or more charitable beneficiaries for the
exclusive benefit of which Capital Stock is transferred, where absent such
transfer the intended transferee of such Capital Stock would beneficially or
constructively own more than a 9.8% interest in any tenant of the Company.
"CMO" or "Collateralized Mortgage Obligations" means adjustable or
short-term fixed-rate debt obligations (bonds) that are collateralized by
Mortgage Loans and issued by private institutions or issued or guaranteed by
GNMA, FNMA or FHLMC.
"Code" means the Internal Revenue Code of 1986, as amended.
"Commitments" means commitments issued by the Company which will obligate
the Company to purchase Mortgage Assets from the holders of the commitment for a
specified period of time, in a specified aggregate principal amount and at a
specified price.
"Common Stock" means one share of the Company common stock, par value
$.001.
"Company" means RealTrust Asset Corporation, a Maryland corporation, and
includes any subsidiaries thereof when the context otherwise requires.
"ContiFinancial Corporation" means ContiFinancial Corporation and each of
its affiliates, including ContiMortgage Corporation, ContiTrade Services,
L.L.C., and ContiFinancial Services Corporation.
"Direct Participant" means Participants which are securities brokers and
dealers, banks, trust companies, clearing corporations and certain other
organizations.
"DRP" means a Dividend Reinvestment Plan the Company intends to adopt
following this Offering.
"DTC" means the Depository Trust Company.
"ERISA" means the Employee Retirement Income Security Act of 1974.
109
<PAGE> 114
"ERISA Plan" or "Plan" means a pension, profit-sharing, retirement or other
employee benefit plan which is subject to ERISA.
"Excess Shares" means the number of shares of Capital Stock of the Company
held by any person or group of persons in excess of 9.8% of the outstanding
shares.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Exercise Price" means the price equal to the Price to Public.
"Expiration Date" means the date and time after which the Warrants are no
longer exercisable or 5:00 p.m. Eastern Time on the third anniversary of the
date the Warrants first become exercisable.
"FHA" means the United States Federal Housing Administration.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"First Lien Mortgage Loans" means Mortgage Loans secured by first mortgages
or deeds of trust.
"FNMA" means the Federal National Mortgage Association.
"Formation Transaction" means the transactions and actions to be taken by
the Company prior to this Offering.
"Founders" means the stockholders of the Taxable Subsidiary prior to this
Offering.
"GAAP" means generally accepted accounting principles.
"GNMA" means the Government National Mortgage Association.
"HUD" means the Department of Housing and Urban Development.
"Independent Directors" means a director of the Company who is not an
officer or employee of the Company or any affiliate or subsidiary of the
Company.
"Indirect Participants" means Participants which are securities brokers and
dealers, banks and trust companies that clear through or maintain a custodial
relationship with a Direct Participant, either directly or indirectly.
"Investment Company Act" means the Investment Company Act of 1940, as
amended.
"IRAs" means Individual Retirement Accounts.
"ISOs" means qualified incentive stock options granted under the Stock
Option Plan which meet the requirements of Section 422 of the Code.
"Keogh Plans" means H.R. 10 Plans.
"LIBOR" means London Inter-Bank Offered Rate.
"Limitation Price" means the price for which any holder of Excess Stock may
designate a transferee of such Excess Stock, which price is equal to the lesser
of (i) in the case of a deemed exchange for Excess Stock resulting from a
transfer, the price paid for such shares in the transfer or, in the case of a
deemed exchange for Excess Stock resulting from some other event, the fair
market value on the date of the deemed exchange, of the shares deemed exchanged,
or (ii) the fair market value of the shares for which such Excess Stock will be
deemed to be exchanged on the date of the designation of the transferee (or, in
the case of a purchase by the Company, on the date the Company accepts the offer
to sell).
"LTV" means loan-to-value ratio which is the percentage obtained by
dividing the principal amount of a loan by the lower of the sales price or
appraised value of the mortgaged property when the loan is originated.
"Maryland GCL" means the Maryland General Corporation Law as in effect on
the date hereof, or as subsequently amended and revised.
"Mortgage Assets" means (i) Mortgage Loans and (ii) Mortgage Securities.
110
<PAGE> 115
"Mortgage Loans" means mortgage loans which are secured by mortgages or
deeds of trust on single-family (one to four unit) residences, and includes
Subprime Mortgage Loans and Prime Mortgage Loans.
"Mortgage Securities" means CMOs and securities (or interests therein)
which are Qualified REIT Assets evidencing undivided ownership interests in a
pool of Mortgage Loans, the holders of which receive a "pass-through" of the
principal and interest paid in connection with the underlying Mortgage Loans in
accordance with the holders' respective, undivided interests in the pool.
"Ownership Limit" means 9.8% of the outstanding shares of each class of
stock, as may be increased or reduced by the Board of Directors of the Company.
"Participants" means participants in the DTC.
"Post-closing Transactions" means the transaction and actions to be taken
by the Company subsequent to this Offering.
"Prime Mortgage Loans" means Mortgage Loans that either comply with
requirements for inclusion in credit support programs sponsored by FHLMC or FNMA
or are FHA or VA Loans, all of which are secured by first mortgages or deeds of
trust on single-family (one to four units) residences.
"Qualified Hedge" means a hedging contract that has each of the following
attributes: (a) a financial instrument; (b) entered into by the Company to hedge
any variable rate indebtedness of the Company incurred or to be incurred to
acquire or carry real estate assets; (c) the Company will not treat as a
Qualified Hedge any hedging instrument acquired to hedge an asset of the
Company; and (d) the Company will only treat as a Qualified Hedge a hedging
instrument acquired to hedge a variable rate indebtedness secured by a variable
rate asset that itself is subject to periodic or lifetime interest rate caps, or
a variable rate indebtedness that is subject to a different interest rate index
from that of the Company's asset securing such variable rate indebtedness.
"Qualified REIT Assets" means pass-through certificates, Mortgage Loans,
Agency Certificates and other assets of the type described in Code Section
856(c)(5)(B).
"Qualified REIT Subsidiary" means a corporation whose stock is entirely
owned by the REIT. The income and assets of a Qualified REIT Subsidiary are
treated as those of the Company for tax purposes.
"Qualifying Interests" means "mortgages and other liens on and interests in
real estate," as defined in Section 3(c)(5)(C) under the Investment Company Act.
"RealTrust" means RealTrust Asset Corporation, a newly formed Maryland
corporation.
"REIT" means Real Estate Investment Trust as defined under Section 856 of
the Code.
"REMIC" means Real Estate Mortgage Investment Conduit as defined under
Section 860D of the Code.
"Representative" means Stifel, Nicolaus & Company, Incorporated.
"Representative's Warrants" means the Warrants to purchase 150,000 shares
of Common Stock (172,500 shares if the over-allotment option is exercised)
granted to the Representative.
"Reverse Repurchase Agreement" means a borrowing device evidenced by an
agreement to sell securities or other assets to a third-party and a simultaneous
agreement to repurchase them at a specified future date and price, the price
difference constituting the interest on the borrowing.
"Second Lien Mortgage Loans" means Mortgage Loans secured by second
mortgages or deeds of trust.
"Securities Act" means the Securities Act of 1933, as amended.
"Strategic Alliance" means the certain strategic alliance between the
Company and ContiFinancial Corporation.
"Subordinated Mortgage Securities" means a class of Mortgage Securities
that is subordinated to one or more of classes of Mortgage Securities, all of
which classes share the same collateral.
111
<PAGE> 116
"Subprime Mortgage Loans" means Mortgage Loans that do not conform to one
or more underwriting criteria of FHLMC and FNMA (other than the mortgage loan
limits) for participation in one or more of such agencies' mortgage loan
programs, and may also exceed the maximum loan limits
"Tax-Exempt Entity" means a qualified pension, profit-sharing or other
employee retirement benefit plan, Keogh Plans, bank commingled trust funds for
such plans, IRAs and other similar entities intended to be exempt from Federal
income taxation.
"Taxable Income" means for any year the taxable income of the Company for
such year (excluding any net income derived either from property held primarily
for sale to customers or from foreclosure property) subject to certain
adjustments provided in Section 857 of the Code.
"Taxable Subsidiary" means CMG Funding Corp., a Delaware corporation.
"UBTI" means "unrelated trade or business income" as defined in Section 512
of the Code.
"Unit" means one share of Common Stock and one Warrant.
"Warrant" means a warrant to purchase one share of Common Stock at the
Price to Public, and included in the Unit.
"Warrant Agent" means the warrant agent named in the Warrant Agreement,
which initially shall be the American Securities Transfer & Trust Incorporated.
"Warrant Agreement" means the warrant agreement pursuant to which the
Warrants will be issued.
"Warrant Share" means a Warrant to purchase one share of Common Stock.
112
<PAGE> 117
INDEPENDENT AUDITORS' REPORT
The Board of Directors
CMG Funding Corp.:
We have audited the accompanying balance sheets of CMG Funding Corp.
(formerly Continental Mortgage Group, L.C.) as of December 31, 1997 and 1996,
and the related statements of operations, stockholders' equity, and cash flows
for the year ended December 31, 1997 and the period from February 7, 1996 (date
of inception) to December 31, 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of CMG Funding Corp. as of
December 31, 1997 and 1996, and the results of its operations and its cash flows
for the year ended December 31, 1997 and the period from February 7, 1996 (date
of inception) to December 31, 1996, in conformity with generally accepted
accounting principles.
KPMG PEAT MARWICK LLP
Salt Lake City, Utah
March 10, 1998
F-1
<PAGE> 118
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
BALANCE SHEETS
DECEMBER 31, 1997 AND 1996
ASSETS
<TABLE>
<CAPTION>
1997 1996
----------- -----------
<S> <C> <C>
Cash and cash equivalents................................... $ 708,962 272,308
Mortgage loans held for sale................................ 54,451,067 24,147,713
Receivables................................................. 1,379,878 120,731
Furniture, fixtures, and equipment, net..................... 1,325,969 500,570
Other real estate owned..................................... -- 147,740
Deposits.................................................... 86,549 56,762
Restricted cash............................................. 56,478 90,009
Organization costs, net of accumulated amortization of
$6,824 at December 31, 1997 and $2,573 at December 31,
1996...................................................... 38,669 16,105
Prepaid expense............................................. 500,174 6,114
Other assets................................................ 319,557 --
----------- -----------
$58,867,303 25,358,052
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable............................................ $ 377,110 207,442
Accrued interest and other liabilities...................... 796,376 536,026
Warehouse and revolving working capital lines of credit..... 55,603,021 23,996,471
Notes payable............................................... 188,690 250,000
Obligations under capital leases............................ 366,687 233,982
Dividends payable........................................... 73,188 --
----------- -----------
Total liabilities................................. 57,405,072 25,223,921
Stockholders' equity:
Class A convertible preferred stock, $.001 par value.
1,268,950 shares authorized, 1,263,472 issued, and
outstanding............................................ 1,263 --
Common stock, $.001 par value. 2,609,407 shares
authorized, 1,546,983 issued, and outstanding.......... 1,547 --
Additional paid-in capital.................................. 4,539,598 --
Members' capital.......................................... -- 1,439,997
Accumulated deficit....................................... (3,080,177) (1,305,866)
----------- -----------
Total stockholders' equity........................ 1,462,231 134,131
----------- -----------
$58,867,303 25,358,052
=========== ===========
</TABLE>
See accompanying notes to financial statements.
F-2
<PAGE> 119
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
<TABLE>
<CAPTION>
1997 1996
----------- -----------
<S> <C> <C>
Revenues:
Interest.................................................. $ 3,756,870 621,601
Gain-on-sale of mortgage loans, net....................... 5,967,647 446,771
Mortgage servicing fees................................... 38,826 --
Other..................................................... 269,248 92,063
----------- -----------
10,032,591 1,160,435
----------- -----------
Expenses:
Salaries and employee benefits............................ 4,474,357 390,018
General operating......................................... 4,313,236 1,285,156
Interest.................................................. 2,965,685 731,519
Other..................................................... 53,624 59,608
----------- -----------
11,806,902 2,466,301
----------- -----------
Net loss.......................................... $(1,774,311) (1,305,866)
=========== ===========
</TABLE>
See accompanying notes to financial statements.
F-3
<PAGE> 120
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
STATEMENTS OF STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
<TABLE>
<CAPTION>
CLASS A
CONVERTIBLE ADDITIONAL TOTAL
PREFERRED COMMON PAID-IN MEMBERS' ACCUMULATED STOCKHOLDERS'
STOCK STOCK CAPITAL CAPITAL DEFICIT EQUITY
----------- ------- ---------- ---------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Balances at February 7, 1996
(date of inception)........ $ -- -- -- -- -- --
Members' capital
contribution............... -- -- -- 1,562,664 -- 1,562,664
Members' withdrawals......... -- -- -- (122,667) -- (122,667)
Net loss..................... -- -- -- -- (1,305,866) (1,305,866)
------ ----- --------- ---------- ----------- -----------
Balances at December
31,1996.................... -- -- -- 1,439,997 (1,305,866) 134,131
Conversions of members'
capital to Class A
convertible preferred stock
(600,774 shares) and common
stock (1,000,100 shares)... 601 1,000 1,438,396 (1,439,997) -- --
Issuance of Class A
convertible preferred stock
(252,117 shares)........... 252 -- 499,748 -- -- 500,000
Conversion of subordinated
debt to common stock
(546,883 shares)........... -- 547 849,453 -- -- 850,000
Conversion of $2,000,000
revolving working capital
line of credit to Class A
convertible preferred stock
(410,581 shares)........... 410 -- 1,999,590 -- -- 2,000,000
Cumulative dividend -- Class
A convertible preferred
stock...................... -- -- (247,589) -- -- (247,589)
Net loss..................... -- -- -- -- (1,774,311) (1,774,311)
------ ----- --------- ---------- ----------- -----------
Balances at December 31,
1997....................... $1,263 1,547 4,539,598 -- (3,080,177) 1,462,231
====== ===== ========= ========== =========== ===========
</TABLE>
See accompanying notes to financial statements.
F-4
<PAGE> 121
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
<TABLE>
<CAPTION>
1997 1996
------------- -------------
<S> <C> <C>
Cash flows from operating activities:
Net loss.................................................. $ (1,774,311) $ (1,305,866)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation and amortization........................... 248,395 54,283
Proceeds from mortgage loans held for sale.............. 462,824,615 148,300,974
Increase in mortgage loans held for sale................ (487,160,322) (172,174,656)
Gain on sales of mortgage loans, net.................... (5,967,647) (446,771)
Write-down of other real estate owned................... -- 25,000
Gain on sale of other real estate owned................. (8,874) --
Proceeds from warehouse and revolving working capital
lines of credit, net.................................. 33,606,550 23,996,471
Changes in operating assets and liabilities:
Increase in receivables.............................. (1,259,147) (120,731)
Increase in deposits................................. (29,787) (56,762)
Decrease (increase) in restricted cash............... 33,531 (90,009)
Increase in organization costs....................... (42,310) (18,678)
Increase in prepaid expense.......................... (494,060) (6,114)
Increase in other assets............................. (319,557) --
Increase in accounts payable......................... 169,668 207,442
Increase in accrued interest and other liabilities... 260,350 536,026
------------- -------------
Net cash provided by (used in) operating
activities...................................... 87,094 (1,099,391)
------------- -------------
Cash flows from investing activities:
Purchase of furniture, fixtures, and equipment............ (784,762) (256,858)
Proceeds from sale of land held for investment............ -- 177,734
Proceeds from sale of other real estate owned............. 156,614 --
------------- -------------
Net cash used in investing activities.............. (628,148) (79,124)
------------- -------------
Cash flows from financing activities:
Proceeds from notes payable............................... 200,000 250,000
Payments on notes payable................................. (261,310) (65,000)
Payments on obligations under capital leases.............. (136,581) (48,726)
Proceeds from subordinated debt........................... 850,000 --
Proceeds from issuance of preferred stock................. 500,000 --
Members' capital contributions, net of withdrawals........ -- 1,314,549
Dividends paid............................................ (174,401) --
------------- -------------
Net cash provided by financing activities.......... 977,708 1,450,823
------------- -------------
Net increase in cash and cash equivalents................... 436,654 272,308
Cash and cash equivalents at the beginning of period........ 272,308 --
------------- -------------
Cash and cash equivalents at end of period.................. $ 708,962 $ 272,308
============= =============
SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION
Interest paid............................................... $ 2,599,437 599,020
SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES
Transfer from mortgage loans held for sale to other real
estate owned.............................................. $ -- 172,740
Land contributed by member, net of note payable in amount of
$65,000................................................... -- 112,734
Office machinery and equipment contributed by member........ -- 12,714
Capital lease obligations incurred for furniture, fixture,
and equipment............................................. 269,286 282,708
Conversion of members capital to preferred, common stock,
and additional paid-in capital............................ 1,439,997 --
Conversion of subordinated debt to common stock and
additional paid-in capital................................ 850,000 --
Conversion of revolving working capital line of credit to
Class A convertible preferred stock and additional paid-in
capital................................................... 2,000,000 --
Dividends payable on cumulative Class A convertible
preferred stock........................................... 73,188 --
</TABLE>
See accompanying notes to financial statements.
F-5
<PAGE> 122
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
(1) DESCRIPTION OF BUSINESS
CMG Funding Corp. (the Company) was incorporated on December 12, 1996,
under the laws of the State of Delaware and began operations on March 7, 1997.
Prior to this, the Company was organized on February 7, 1996, in the State of
Utah as a limited liability company and operated as Continental Mortgage Group.
The Company is engaged in mortgage banking activities located throughout the
United States.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Financial Statement Presentation
The financial statements have been prepared in conformity with generally
accepted accounting principles. In preparing the financial statements,
management is required to make estimates and assumptions that affect the
reported amounts of assets and liabilities as of the date of the balance sheet
and revenues and expenses for the period. Actual results could differ from those
estimates.
(b) Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid
investments with original maturities of three months or less. The carrying
amount of cash equivalents approximates their value.
The Company has cash in a financial institution which is insured by the
Federal Deposit Insurance Corporation (FDIC) up to $100,000 per institution. As
of December 31, 1997, the Company had amounts on deposit with the financial
institution in excess of FDIC limits. The Company limits its risk by placing its
cash in a high quality financial institution.
At December 31, 1997 and 1996, restricted cash includes $56,478 and
$90,009, respectively, representing cash restricted for the purpose of warehouse
loan fundings.
(c) Mortgage Loans Held for Sale
Mortgage loans held for sale are valued at the lower of cost or estimated
market value as determined by outstanding commitments from investors or current
investor yield requirements calculated on a loan-by-loan basis. Mortgage loans
held for sale include loan premiums of $1,322,339 and $242,553 at December 31,
1997 and 1996, respectively.
The Company has limited its exposure to credit losses on its mortgage loans
held for sale by performing an in-depth due diligence on every loan originated
and purchased. The due diligence encompasses the borrowers credit, the
enforceability of the documents, and the value of the mortgage property. The
Company has not experienced any credit losses to date.
(d) Loan Origination Fees and Related Costs
Loan origination fees and certain direct loan origination costs are
deferred, and the net fee or cost is recognized in income using the interest
method over the contractual life of the loans, adjusted for estimated
prepayments based on the Company's historical prepayment experience. The net
deferred loan fee or cost is used in calculating the Company's gain or loss when
the related loans are sold to investors.
F-6
<PAGE> 123
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
(e) Furniture, Fixtures, and Equipment
Furniture, fixtures, and equipment are stated at cost. Depreciation and
amortization are computed using the straight-line method based on the estimated
useful lives of the related assets. Useful lives range from five to seven years,
with the exception of leasehold improvements which are amortized over the lease
term or estimated useful life, whichever is less. Software is amortized over a
three-year life.
Furniture and equipment under capital lease is stated at the present value
of minimum lease payments at the inception of the lease. Depreciation under
capital leases is computed using the straight-line method over the estimated
useful life of the underlying asset.
(f) Organization Costs
Organization costs associated with the organization of the Company are
amortized on a straight-line basis over five years.
(g) Gain/Loss on Sale of Mortgage Loans
When loans are sold, a gain or loss is recognized to the extent that the
sales proceeds exceed or are less than the net book value of the loans. Net
deferred loan fees or costs are included in calculating gains and losses from
sales on loans.
(h) Mortgage Servicing Fees
Mortgage servicing fees represent the fees earned for servicing mortgage
loans under servicing agreements with the Federal National Mortgage Association
(FNMA). The fees are based on a fixed amount per loan and are recorded as income
when received.
(i) Income Taxes
Prior to March 7, 1997, the Company was a limited liability company (LLC)
under the provisions of the Internal Revenue Code. As a result, the Company paid
no federal or state income taxes, and the elements of income or loss were
includable in the individual members' income tax returns.
Upon the merger of CMG Funding Corp. into Continental Mortgage Group LLC,
with CMG Funding, a "C" Corporation, the survivor, the Company became subject to
income taxes which are recognized using the asset and liability method. Under
the asset and liability method, deferred tax assets and deferred tax liabilities
are recognized for the future tax consequences attributable to differences
between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and deferred tax liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The
effect on deferred tax assets and deferred tax liabilities of a change in tax
rates is recognized in operations in the period that includes the enactment
date.
(j) Recent Accounting Pronouncements
On March 7, 1997, the Company adopted Statement of Financial Accounting
Standards (Statement) No. 123, Accounting for Stock-Based Compensation, which
permits entities to recognize as expense over the vesting period, the fair value
of all stock-based awards on the date of the grant. Alternatively, Statement No.
123 also allows entities to continue to apply the provisions of APB Opinion No.
25 and provide pro forma
F-7
<PAGE> 124
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
earnings (loss) and pro forma earnings (loss) per share disclosure for employee
stock option grants made in 1995 and future years as if the fair-value-based
method defined in Statement No. 123 had been applied. The Company has elected to
apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure
provisions of Statement No. 123.
Statement No. 125, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, as amended by Statement No. 127, is
effective for all transfers and servicing of financial assets and
extinguishments of liabilities occurring after December 31, 1996, except for
secured borrowings and collateral, repurchase agreements, dollar rolls,
securities lending, and similar transactions, which transfers will be effective
for transactions occurring after December 31, 1996. This statement provides
accounting and reporting standards for transfers and servicing of financial
assets and extinguishments of liabilities based on consistent application of
financial-components approach that focuses on control. It distinguishes
transfers of financial assets that are sales from transfers that are secured
borrowings. Under the financial-components approach, after a transfer of
financial assets, an entity recognizes all financial and servicing assets it
controls and liabilities it has incurred and derecognizes financial assets it no
longer controls and liabilities that have been extinguished. Many of these
assets and liabilities are components of financial assets that existed prior to
the transfer. If a transfer does not meet the criteria for a sale, the transfer
is accounted for as a secured borrowing with a pledge of collateral.
(k) Financial Statement Presentation
The Company prepares its financial statements using an unclassified balance
sheet presentation as is customary in the mortgage banking industry. A
classified balance sheet presentation would have aggregated current assets,
current liabilities, and net working capital (deficit) as follows as of December
31:
<TABLE>
<CAPTION>
1997 1996
----------- ----------
<S> <C> <C>
Current assets............................................. $57,040,081 24,636,875
Current liabilities........................................ 55,227,715 24,901,914
----------- ----------
Net working capital (deficit).............................. $ 1,812,366 (265,039)
=========== ==========
</TABLE>
(l) Reclassification
Certain balances in 1996 have been reclassified to conform to the 1997
presentation
(3) RECEIVABLES
Receivables as of December 31, 1997 and 1996, consist of the following:
<TABLE>
<CAPTION>
1997 1996
---------- ----------
<S> <C> <C>
Mortgage payments........................................... $ 831,547 40,721
Accrued interest............................................ 463,720 71,616
Investor bonus.............................................. 79,134 --
Other receivables........................................... 5,477 8,394
---------- ----------
$1,379,878 120,731
========== ==========
</TABLE>
F-8
<PAGE> 125
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
(4) FURNITURE, FIXTURES, AND EQUIPMENT
Furniture, fixtures, and equipment at December 31, 1997 and 1996, consist
of the following:
<TABLE>
<CAPTION>
USEFUL LIVES 1997 1996
------------ ----------- -------
<S> <C> <C> <C>
Furniture and fixtures............................ 7 years $ 323,105 146,836
Office machinery and equipment.................... 5 - 7 years 438,544 112,989
Computers......................................... 5 years 514,957 186,591
Software.......................................... 3 years 265,912 92,396
Leasehold improvements............................ 2 - 5 years 63,809 13,468
----------- -------
1,606,327 552,280
Less accumulated depreciation and amortization.... 280,358 51,710
----------- -------
$ 1,325,969 500,570
=========== =======
</TABLE>
(5) WAREHOUSE AND REVOLVING WORKING CAPITAL LINES OF CREDIT
The Company had the following lines of credit for the periods ending
December 31, 1997 and 1996:
<TABLE>
<CAPTION>
1997 1996
----------- ----------
<S> <C> <C>
2,000,000 revolving working capital line of credit with a
finance company, maturing in January of 1999, with
interest on outstanding balance accruing at LIBOR plus
4.5% to 8.5%, secured by general assets (note 15)......... $ 1,785,225 200,000
7,000,000 warehousing line of credit with a finance company,
maturing in June of 1997, with interest on outstanding
balance accruing at the bank's prime rate plus 0.25%,
payable monthly, secured by loans and servicing rights in
loans warehoused.......................................... -- 6,888,713
12,000,000 warehousing line of credit with a financial
institution, matures in July of 1997, with interest
accruing on outstanding balance ranging from LIBOR plus
2.15% to 2.75%, payable monthly, secured by loans
warehoused and associated servicing rights................ -- 10,248,546
4,000,000 warehousing line of credit with a financial
institution, maturing in April of 1997, with interest on
outstanding balance accruing at the bank's prime rate plus
0.50%, payable monthly, secured by loans warehoused and
associated servicing rights............................... -- 2,590,759
50,000,000 warehousing line of credit with a finance
company, maturing in January of 1999, with interest on
outstanding balance accruing at LIBOR plus 2.25%, payable
monthly, secured by loans warehoused and associated
servicing rights (note 15)................................ 31,692,828 4,068,453
10,000,000 warehousing line of credit with a financial
institution, maturing in May of 1998, with interest
accruing on outstanding balance ranging from LIBOR plus 2%
to 3%, payable monthly, secured by loans warehoused and
associated servicing rights............................... 57,362 --
100,000,000 reverse repurchase agreement with a finance
company, maturing in October of 1998, with interest on
outstanding balance ranging from LIBOR plus 1.10% to
3.25%..................................................... 22,067,606 --
----------- ----------
Total warehouse and revolving working capital
lines of credit................................. $55,603,021 23,996,471
=========== ==========
</TABLE>
F-9
<PAGE> 126
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
Effective November 24, 1997, the $2 million revolving line of credit was
renewed and amended to provide $4 million of revolving credit, maturing August
1, 1998. In connection therewith the Company issued a common stock warrant to
the finance company (note 15). The terms of the warrant provided that it could
only be exercised if the Company did not repay in full, the outstanding balance
on the line of credit. If exercised, the warrant entitled the finance company to
purchase for one dollar a number of shares equivalent to a maximum of 13 percent
of the Company's equity on a fully-diluted basis.
Effective December 31, 1997, the finance company converted $2 million of
the $4 million revolving line of credit for 410,581 shares of Class A
convertible preferred stock. Further, the revolving line of credit was renewed
and amended to provide a $2 million revolving credit, maturing January 1, 1999.
In connection therewith, the Company granted to the finance company two
warrants to purchase shares of common stock. The first warrant allows the
finance company to purchase, for a nominal amount, up to five percent of the
Companyis outstanding common shares (on a fully-diluted basis) if all principal
and interest due under the revolving line of credit is not repaid on or prior to
January 1, 1999. This warrant, if it becomes exercisable, will remain
exercisable for a period of ten years. The second warrant entitles the finance
company to purchase, for a nominal amount, one percent of the Companyis
outstanding stock (on a fully-diluted basis) for each calendar quarter during
1998 in which, the Company fails to attain at least 90 percent of a pretax
income target described in the agreement. Entitlements under this warrant may be
exercised prior to the earlier of repayment or January 1, 1999.
Additionally, the warrant issued to the finance company in November 1997
was canceled upon the granting of the two warrants described above.
The Company's warehousing and revolving working capital line of credit
agreements referred to above contain both financial and nonfinancial covenants.
As of December 31, 1997, the Company, with the exception of the $10 million
warehouse line of credit, was in compliance with all covenants under the credit
agreements.
(6) NOTES PAYABLE
Notes payable consisted of the following at December 31:
<TABLE>
<CAPTION>
1997 1996
-------- --------
<S> <C> <C>
Note payable to a related party, unsecured, with interest on
outstanding balance accruing at 12.0%, paid quarterly,
principal due on December 31, 2000........................ $150,000 --
Note payable to a financial institution, maturing March
2000, with interest on outstanding balance accruing at
11.5%, payable monthly, secured by furniture and
equipment................................................. 38,690 --
Note payable to a financial institution, at a fixed rate of
10.25%, due February 1997................................. -- 250,000
-------- --------
$188,690 250,000
======== ========
</TABLE>
(7) SUBORDINATED DEBT
On December 17, 1996, the Company entered into a subordinated debt
agreement with a finance company that permitted the Company to borrow $850,000
at 15 percent interest if certain origination volumes were met as described in
the agreement; otherwise, the interest rate was 18 percent. The subordinated
debt was originally convertible into 429,293 shares of convertible preferred
stock, at the option of the finance company, for a conversion price of $1.98 per
share.
F-10
<PAGE> 127
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
Effective, November 24, 1997, the Company and the finance company modified
the agreement providing for a conversion privilege to common stock. In
accordance with such modifications, the finance company exercised its conversion
privilege by converting the subordinated debt into 546,883 shares of common
stock.
(8) CAPITAL STOCK
The Company's convertible preferred stock entitles the stockholder to
receive a dividend at the annual rate of 18 percent of the original issue price,
of $1.98 per share. The dividends are cumulative and are payable quarterly, in
arrears on the last day of each quarter end. The dividends accrue whether or not
the Company has earnings, funds are legally available for payment, and dividends
are declared. In addition, each share is convertible to common stock at any time
subsequent to issuance, at the option of the stockholder, as determined by
dividing the original issue price by the conversion price defined in the
Certification of Incorporation of the Company.
During December 1996, the Company adopted a stock option plan (the Plan),
which provides for grants of incentive and nonqualified stock options. Under
this Plan, the Company has granted nonqualified stock options to officers,
directors, and other key individuals providing significant services to the
Company. The number of shares, terms, and exercise periods are determined by the
Board of Directors on an option-by-option basis. All options granted have a
ten-year exercise period and vest over a three-year period. An aggregate of
226,905 shares have been authorized for issuance under this plan. None of the
options outstanding as of December 31, 1997 are exercisable.
A summary of the activity for the year ended December 31, 1997 under this
Plan follows:
<TABLE>
<CAPTION>
WEIGHTED-AVERAGE
SHARES EXERCISE PRICE
------ ----------------
<S> <C> <C>
Outstanding at beginning of period.......................... -- $ --
Granted..................................................... 97,000 3.96
------ -----
Outstanding at end of period................................ 97,000 $3.96
====== =====
Weighted-average:
Fair value of options granted during the period........... $ 0.68
Remaining contractual life................................ 8.96 years
</TABLE>
The Company accounts for the Plan according to APB 25, under which
compensation cost will be recognized over the expected life of the options for
the difference between the exercise price and the related fair value. Inasmuch
as the Company's Board of Directors and management believes, the exercise price
to reflect the fair value of the options at date of grant, no compensation cost
was recorded for the year ended December 31, 1997. Had compensation cost for the
Plan been determined consistent with Statement No. 123, the Company's December
31, 1997 net loss would have been increased as follows:
<TABLE>
<S> <C>
Net loss:
As reported............................................... $1,774,311
Pro forma................................................. 1,786,661
</TABLE>
The effect that calculating compensation cost for stock-based compensation
under Statement No. 123 has on the pro forma net loss as presented above may not
be representative of the effects on reported net earnings or losses for future
years.
F-11
<PAGE> 128
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
The fair value of each option grant is estimated on the date of grant using
an option pricing model with the following weighted-average assumptions: risk
free interest rate of six percent; expected dividend yields of zero percent; and
expected lives of three years.
Subsequent to December 31, 1997, the Company canceled 27,500 options to
employees and a director to acquire shares of common stock at an exercise price
of $3.96.
(9) LOAN SERVICING
For the year ended December 31, 1997, the Company was servicing
approximately eight loans, owned by investors, aggregating $993,384. In
connection with its loan administration activities, the Company makes certain
payments of property taxes, insurance premiums, and guaranteed payments in
advance of collecting them from specific mortgagors.
(10) EMPLOYEE BENEFIT PLANS
The Company has a qualified 401(k) retirement plan for all employees who
have completed three months of service and have attained the age of 21.
Participants are able to contribute, on a pre-tax basis, up to 15 percent of
their earnings to the plan. Employer matching contributions are discretionary,
to be set prior to the end of the plan year, computed quarterly, and allocated
based on the ratio of the participants' compensation to total participants'
compensation.
(11) INCOME TAXES
As discussed in note 2, the Company became subject to income taxes
following the merger on March 7, 1997. There is no income tax subsequent to that
date due to operating losses. The difference between the expected tax benefit
and the actual benefit is primarily attributable to the effect of net operating
losses being offset by the Company's valuation allowance.
The tax effect of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at December 31,
1997, are presented below:
<TABLE>
<S> <C>
Deferred tax asset:
Net operating loss carryforwards.......................... $472,150
Mark to market adjustment................................. 8,750
Other..................................................... 4,000
--------
Total gross deferred tax assets................... 484,900
Deferred tax liabilities -- furniture, fixtures, and
equipment due to differences in depreciation.............. 40,000
--------
Net deferred tax asset before valuation allowance........... 444,900
Less valuation allowance.................................... 444,900
--------
Net deferred tax asset............................ $ --
========
</TABLE>
Subsequently recognized tax benefits relating to the valuation allowance
for deferred tax assets will be allocated as an income tax benefit to be
reported in the statements of operations. At December 31, 1997, the Company had
tax net operating losses approximately of $1,269,000, which can be carried
forward to reduce federal income taxes.
F-12
<PAGE> 129
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
(12) LEASES
The Company is obligated under operating leases for furniture, equipment,
and office space. In addition, the Company leases certain office equipment under
agreements that are recorded as capital leases. Future minimum lease payments
under noncancelable operating leases (with initial or remaining lease terms in
excess of one year) and minimum capital lease payments as of December 31, 1997,
are as follows:
<TABLE>
<CAPTION>
CAPITAL OPERATING
LEASES LEASES
-------- ----------
<S> <C> <C>
Period ending December 31:
1998...................................................... $216,835 $ 763,387
1999...................................................... 160,310 705,032
2000...................................................... 48,544 627,884
2001...................................................... 5,701 595,820
2002...................................................... 2,315 155,272
-------- ----------
Total minimum lease payments...................... 433,705 $2,847,395
==========
Less amount representing interest........................... 67,018
--------
Present value of net minimum lease payments....... $366,687
========
</TABLE>
Furniture and equipment held under capital leases and the related
accumulated amortization at December 31, 1997, is as follows:
<TABLE>
<S> <C>
Furniture and fixtures...................................... $111,114
Office machinery and equipment.............................. 363,416
Computers................................................... 68,093
--------
542,623
Less accumulated amortization............................... 109,586
--------
$433,037
========
</TABLE>
Rental expense under operating leases was $648,314 and $277,377 for the
year ending December 31, 1997 and the period from February 7, 1996 (date of
inception) to December 31, 1996, respectively.
(13) COMMITMENTS AND CONTINGENCIES
The Company is involved in various claims and legal actions arising in the
ordinary course of business. In the opinion of management, the ultimate
disposition of these matters will not have a material adverse effect on the
Company.
(14) CONCENTRATIONS OF CREDIT RISK
A significant portion of loans originated and purchased, and held for sale
are single family residence mortgage loans.
For the year ended December 31, 1997, mortgage loans purchased and
originated by the Company were geographically concentrated in Utah, Florida,
Georgia, and California. The Company has no other significant concentration of
credit risk. The Company manages its credit risk through diversification of
markets in which the Company originates and purchases mortgage loans.
F-13
<PAGE> 130
CMG FUNDING CORP.
(FORMERLY CONTINENTAL MORTGAGE GROUP L.C.)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 AND PERIOD FROM FEBRUARY 7, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996
(15) RELATED PARTY
One of the Company's holders of 662,698 shares Class A convertible
preferred stock and 546,883 shares common stock is a finance company from which
the Company has borrowings as follows as of December 31, 1997 and 1996,
respectively (notes 5 and 7):
<TABLE>
<CAPTION>
1997 1996
----------- ----------
<S> <C> <C>
Warehouse line of credit................... $31,692,828 $4,068,453
=========== ==========
Revolving working capital line of credit... $ 1,785,225 $ 200,000
=========== ==========
</TABLE>
The Company is obligated to offer to sell to the finance company 75 percent
of the principal balance of all subprime mortgage loan monthly production by the
Company for 1997 and 1996, 50 percent in 1998, and 25 percent thereafter until
2000. For the periods ended December 31, 1997 and 1996, the Company sold, under
this agreement, loan production in the amounts of $98,042,000 and $16,140,000,
respectively.
F-14
<PAGE> 131
======================================================
NO DEALER, SALES REPRESENTATIVE OR OTHER PERSON HAS BEEN AUTHORIZED TO GIVE
ANY INFORMATION OR MAKE ANY REPRESENTATIONS IN CONNECTION WITH THIS OFFERING
OTHER THAN THOSE CONTAIN IN THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH OTHER
INFORMATION AND REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN
AUTHORIZED BY THE COMPANY OR THE UNDERWRITERS. NEITHER THE DELIVERY OF THIS
PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE
ANY IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY
SINCE THE DATE HEREOF OR THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF
ANY TIME SUBSEQUENT TO ITS DATE. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO
SELL OR A SOLICITATION OF AN OFFER TO BUY ANY SECURITIES OTHER THAN THE
REGISTERED SECURITIES TO WHICH IT RELATES. THIS PROSPECTUS DOES NOT CONSTITUTE
AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY SUCH SECURITIES IN ANY
CIRCUMSTANCES IN WHICH SUCH OFFER OR SOLICITATION IS UNLAWFUL.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary.................... 1
Risk Factors.......................... 14
The Company........................... 31
Use of Proceeds....................... 31
Dividend Policy and Distributions..... 32
Dividend Reinvestment Plan............ 32
Dilution.............................. 33
Capitalization........................ 34
Selected Financial Data............... 35
Management's Discussion and Analysis
of Financial Condition and Results
of
Operations.......................... 36
Business.............................. 39
Management............................ 69
Structure and Formation
Transactions........................ 79
Certain Transactions.................. 81
Principal Stockholders................ 84
Description of Capital Stock.......... 84
Shares Eligible for Future Sale....... 93
Federal Income Tax Considerations..... 95
Underwriting.......................... 105
Legal Matters......................... 106
Experts............................... 107
Additional Information................ 107
Glossary.............................. 108
Table of Contents to Financial
Statements.......................... F-1
</TABLE>
------------------------
UNTIL , 1998, ALL DEALERS EFFECTING
TRANSACTIONS IN THE UNITS, WHETHER OR NOT PARTICIPATING
IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A
PROSPECTUS. THIS DELIVERY REQUIREMENT IS IN ADDITION TO
THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN
ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD
ALLOTMENTS OR SUBSCRIPTIONS.
======================================================
======================================================
[LOGO]
5,000,000 UNITS
REALTRUST ASSET
CORPORATION
CONSISTING OF
ONE SHARE OF COMMON STOCK
AND ONE STOCK
PURCHASE WARRANT
------------------------
PROSPECTUS
MARCH , 1998
------------------------
STIFEL, NICOLAUS & COMPANY
INCORPORATED
EVEREN SECURITIES, INC.
======================================================
<PAGE> 132
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 30. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
ITEM 31. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
The following table sets forth the costs and expenses, other than
underwriting discounts and commissions, payable by the Registrant in connection
with the sale of Common Stock being registered. All amounts are estimates except
the SEC registration fee and the American Stock Exchange ("AMEX") filing fee.
<TABLE>
<CAPTION>
AMOUNT
TO BE
PAID
------
<S> <C>
SEC Registration Fee........................................ $55,094.71
AMEX filing fee............................................. $ *
NASD filing fee............................................. $ 8,000.00
Printing and engraving expenses............................. $ *
Legal fees and expenses..................................... $ *
Accounting fees and expenses................................ $ *
Blue Sky fees and expenses.................................. $ *
Transfer agent and custodian fee............................ $ *
Miscellaneous............................................... $ *
----------
Total............................................. $ 850,000
==========
</TABLE>
- ---------------
* To be filed by amendment
All amounts estimated except for Securities and Exchange Commission
registration fee.
ITEM 32. SALES TO SPECIAL PARTIES.
See Item 33 for description of securities of the Company issued to
affiliates of the Company for cash and other consideration.
ITEM 33. RECENT SALES OF UNREGISTERED SECURITIES.
On [April 1, 1998], the Registrant issued shares of common stock and
preferred stock to nine persons in exchange for shares of capital stock of CMG
Funding Corp., a Delaware corporation. In March 1998, the Company issued an
$850,000 Convertible Secured Promissory Note and granted warrants to purchase
50,000 shares of Registrant's common stock at an exercise price equal to the
public offering price to one accredited investor.
ITEM 34. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
Maryland GCL provides that a Maryland corporation may indemnify any person
who is or was serving at the request of the corporation as a director, officer,
partner, trustee, employee, or agent of another foreign or domestic corporation,
partnership, joint venture, trust or other enterprise or employee benefit plan
("director"), that is made a party to any proceeding by reason of service in
that capacity unless it is established that the act or omission of the director
was material to the matter giving rise to the proceeding and was committed in
bad faith or was the result of active and deliberate dishonesty; or the director
actually received an improper personal benefit in money, property or services;
or, in the case of any criminal proceeding, the director had reasonable cause to
believe that the act or omission was unlawful. Indemnification may be against
judgments, penalties, fines, settlements, and reasonable expenses actually
incurred by the director in connection with the
II-1
<PAGE> 133
proceeding, but if the proceeding was won by or in the right of the corporation,
indemnification may not be made in respect of any proceeding in which the
director shall be adjudged to be liable to the corporation. Such indemnification
may not be made unless authorized for a specific proceeding after a
determination has been made, in a manner prescribed by law, that indemnification
is permissible in the circumstances because the director has met the applicable
standard of conduct. The director must be indemnified for expenses, however, if
he has been successful in the defense of the proceeding or as otherwise ordered
by a court. The law also prescribes the circumstances under which a corporation
may advance expenses to, or obtain insurance or similar coverage for directors.
The Company's Amended and Restated Articles of Incorporation provide for
indemnification of the officers and directors of the Company and eliminate the
liability of a director or officer to the Company or its stockholders for money
damages to the fullest extent permitted by Maryland law.
ITEM 35. TREATMENT OF PROCEEDS FROM STOCK BEING REGISTERED.
Not applicable.
ITEM 36. FINANCIAL STATEMENTS AND EXHIBITS.
(a) Financial Statements
(b) Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
* 1.1 Underwriting Agreement with Stifel, Nicolaus & Company,
Incorporated.
* 3.1 Amended and Restated Articles of Incorporation.
* 3.2 Bylaws.
* 4.1 Specimen Stock Certificate for Common Stock of RealTrust
Asset Corporation.
* 4.2 Warrant Agreement.
* 4.3 1996 Stock Option Plan of CMG Funding Corp.
* 4.4 Form of 1996 Stock Option Agreement.
* 4.5 1998 Stock Option Plan of RealTrust Asset Corporation.
* 4.6 Form of 1998 Stock Option Agreement.
* 4.7 Form of Registration Rights Agreement.
* 4.8 Warrant Agreement No. 2 with ContiFinancial Corporation.
* 4.9 Warrant Agreement No. 3 with ContiFinancial Corporation.
* 4.10 Warrant Agreement with Capstone Investments, Inc.
* 4.11 Convertible Secured Note in favor of Capstone Investments,
Inc.
* 5.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP regarding
legality of Securities.
* 8.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP regarding
certain tax matters. (included in Exhibit 5.1)*
*10.1 Employment Agreement with John D. Fry.
*10.2 Employment Agreement with Terry L. Mott.
*10.3 Employment Agreement with John P. McMurray.
*10.4 Employment Agreement with Steven K. Passey.
*10.5 Investment Banking Service Agreement with ContiFinancial
Corporation, as amended.
*10.6 Loan Servicing Agreement with Advanta Mortgage Corp USA for
CMG Funding Corp., as amended.
*10.7 Loan Servicing Agreement with Nomura Asset Capital
Corporation for CMG Funding Corp.
</TABLE>
II-2
<PAGE> 134
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
*10.8 Purchase and Sale Agreement between ContiTrade Services LLC
and CMG Funding Corp., as amended.
*10.9 Warehouse Credit and Security Agreement between Bank United
and CMG Funding Corp.
*10.10 Standby and Working Capital Agreement between ContiTrade
Services LLC and CMG Funding Corp., as amended
*10.11 Conversion Letter No. 1 from ContiFinancial Corporation.
*10.12 Conversion Letter No. 2 from ContiFinancial Corporation.
*10.13 Registration Rights Agreement with ContiFinancial
Corporation. Stock Pledge and Put Agreement
*21.1 List of subsidiaries.
*23.1 Consent of Counsel (included in Exhibit (5.1).
*23.2 Consent of independent auditors.
24.1 Power of Attorney (included in signature page).
*27.1 Financial Data Schedule.
</TABLE>
- ---------------
* To be filed by amendment.
ITEM 37. UNDERTAKINGS
A. The undersigned Registrant hereby undertakes:
(1) To file, during any period in which offers or sales are being
made, a post-effective amendment to this Registration Statement:
(i) To include any Prospectus required by Section 10(a)(3) of the
Securities Act of 1933;
(ii) To reflect in the Prospectus any facts or events arising after
the effective date to the Registration Statement (or the most recent
post-effective amendment thereof) which, individually or in the
aggregate, represent a fundamental change in the information set forth
in the Registration Statement; and
(iii) To include any material information with respect to the plan
of distribution not previously disclosed in the Registration Statement
or any material change to such information in the Registration
Statement;
Provided, however, that paragraphs A(1)(i) and A(1)(ii) do not apply
if the information required to be included in a post-effective amendment by
those paragraphs is contained in the periodic reports filed by the
Registrant pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 that are incorporated by reference in the Registration Statement
(2) That, for the purpose of determining liability under the
Securities Act of 1933, each such post-effective amendment shall be deemed
to be a new Registration Statement relating to the securities offered
therein, and the offering of such securities at that time shall be deemed
to be the initial bona fide offering thereof;
(3) To remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering.
B. The undersigned registrant hereby undertakes that, for purposes of
determining any liability under the Securities Act of 1933, each filing of the
registrant's annual report pursuant to Section 13(a) or Section 15(d) of the
Securities Exchange Act of 1934 (and, where applicable, each filing of an
employee benefit plan's annual report pursuant to Section 15(d) of the
Securities Exchange Act of 1934) that is incorporated by reference in the
registration statement shall be deemed to be a new registration statement
relating to the
II-3
<PAGE> 135
securities offered therein, and the offering of such securities at the time
shall be deemed to be the initial bona fide offering thereof.
C. The undersigned registrant hereby undertakes to supplement the
prospectus, after the expiration of a subscription period, to set forth the
results of the subscription offer, the transactions by the Underwriters, if any,
during the subscription period, the amount of unsubscribed securities to be
purchased by the Underwriters, if any, and the terms of any subsequent
reoffering thereof, if applicable. If any public offering by the Underwriters is
to be made on terms differing from those set forth on the cover page of the
prospectus, a post-effective amendment will be filed to set forth the terms of
such offering.
II-4
<PAGE> 136
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the undersigned
registrant certifies that it has reasonable grounds to believe that it meets all
of the requirements for filing on Form S-11 and has duly caused this
registration statement to be signed on its behalf by the undersigned, thereunto
duly authorized, in Salt Lake City, Utah, on the 25th day of March, 1998.
REALTRUST ASSET CORPORATION
By: /s/ JOHN D. FRY
------------------------------------
John D. Fry
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints John D. Fry and Terry L. Mott, and each of them,
his true and lawful attorneys-in-fact and agent, with full power of substitution
and resubstitution, for him and in his name, and in any and all capacities, to
sign any and all amendments (including post-effective amendments) to the
Registration Statement to which this power of attorney is attached, as well as
any registration statement (or amendment thereto) relating to one or more of the
offerings covered hereby filed pursuant to Rule 462(b) promulgated under the
Securities Act of 1933, as amended, and to file the same and all exhibits to
them and other documents to be filed in connection with them, with the
Securities and Exchange Commission.
Pursuant to the requirements of the Securities Act of 1933, this
registration statement has been signed by the following persons in the
capacities as Directors and Officers of RealTrust Asset Corporation on the date
indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <C> <S>
/s/ JOHN D. FRY Chairman, Chief Executive March 25, 1998
- ----------------------------------------------------- Officer and President
John D. Fry
/s/ STEVEN K. PASSEY Chief Financial Officer March 25, 1998
- ----------------------------------------------------- and Treasurer
Steven K. Passey (principal accounting officer)
/s/ TERRY L. MOTT Director March 25, 1998
- -----------------------------------------------------
Terry L. Mott
/s/ CARTER E. JONES Director March 25, 1998
- -----------------------------------------------------
Carter E. Jones
</TABLE>
II-5
<PAGE> 137
EXHIBIT INDEX
<TABLE>
<CAPTION>
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER DESCRIPTION PAGE
------- ----------- ------------
<S> <C> <C>
* 1.1 Underwriting Agreement with Stifel, Nicolaus & Company,
Incorporated.
* 3.1 Amended and Restated Articles of Incorporation.
* 3.2 Bylaws.
* 4.1 Specimen Stock Certificate for Common Stock of RealTrust
Asset Corporation.
* 4.2 Warrant Agreement.
* 4.3 1996 Stock Option Plan of CMG Funding Corp.
* 4.4 Form of 1996 Stock Option Agreement.
* 4.5 1998 Stock Option Plan of RealTrust Asset Corporation.
* 4.6 Form of 1998 Stock Option Agreement.
* 4.7 Form of Registration Rights Agreement.
* 4.8 Warrant Agreement No. 2 with ContiFinancial Corporation.
* 4.9 Warrant Agreement No. 3 with ContiFinancial Corporation.
* 4.10 Warrant Agreement with Capstone Investments, Inc.
* 4.11 Convertible Secured Note in favor of Capstone Investments,
Inc.
* 5.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP regarding
legality of Securities.
* 8.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP regarding
certain tax matters. (included in Exhibit 5.1)*
*10.1 Employment Agreement with John D. Fry.
*10.2 Employment Agreement with Terry L. Mott.
*10.3 Employment Agreement with John P. McMurray.
*10.4 Employment Agreement with Steven K. Passey.
*10.5 Investment Banking Service Agreement with ContiFinancial
Corporation, as amended.
*10.6 Loan Servicing Agreement with Advanta Mortgage Corp USA for
CMG Funding Corp., as amended.
*10.7 Loan Servicing Agreement with Nomura Asset Capital
Corporation for CMG Funding Corp.
*10.8 Purchase and Sale Agreement between ContiTrade Services LLC
and CMG Funding Corp., as amended.
*10.9 Warehouse Credit and Security Agreement between Bank United
and CMG Funding Corp.
*10.10 Standby and Working Capital Agreement between ContiTrade
Services LLC and CMG Funding Corp., as amended
*10.11 Conversion Letter No. 1 from ContiFinancial Corporation.
*10.12 Conversion Letter No. 2 from ContiFinancial Corporation.
*10.13 Registration Rights Agreement with ContiFinancial
Corporation.
*21.1 List of subsidiaries.
*23.1 Consent of Counsel (included in Exhibit (5.1).
*23.2 Consent of independent auditors.
24.1 Power of Attorney (included in signature page).
*27.1 Financial Data Schedule.
</TABLE>
- ---------------
* To be filed by amendment.
